September 2008 Legal Briefs

  1. Two Changes to Servicemembers’ Civil Relief Act
  2. Tax Credit for First-Time Homebuyers
  3. Can Banks Freeze Home-Equity Lines of Credit?

1. Two Changes to Servicemembers’ Civil Relief Act

The Housing and Economic Recovery Act of 2008 (HERA) was enacted in July. It includes a variety of provisions providing relief to homeowners with distressed mortgages. It expands the lending authority of Fannie Mae and Freddie Mac, enabling them to refinance more subprime mortgages; and it creates a new supervisory agency for these two government-sponsored entities. But HERA also includes a “kitchen sink full” of miscellaneous provisions—some of which have not even been mentioned by the media.  

I was surprised to learn by paging through the bill that HERA amends two sections of the Servicemembers’ Civil Relief Act (SCRA), which I discuss below.  (If you are unfamiliar with SCRA, it’s the law that requires interest on loans to be reduced to 6% when someone goes on military active-duty status—with the reduction continuing until the person is no longer on active duty.  In most cases SCRA also prevents a lender from taking collection-related actions while a borrower is on active duty—whether that involves suing to obtain a judgment, foreclosing a mortgage, or repossessing other collateral.)

1. Foreclosure of Mortgages

The pre-existing language of Section 303 of SCRA (50 U.S.C. App. 533) states that sale, foreclosure or seizure of real property for breach of a mortgage obligation is not valid during the period of a servicemember’s military service or within 90 days afterward.  (The lender’s exercise of remedies with respect to the real estate is temporarily frozen or suspended, allowing the servicemember an opportunity to return home to deal with it. For fairness reasons, this statute gives the person three months after return, to negotiate directly with the lender, or to become ready to appear in court personally, or perhaps to start a job that will allow him or her to begin straightening out any lapsed financial obligations.)

In HERA (Section 2203) Congress has adopted a temporary amendment to this provision. The “freeze” period (after active duty) is lengthened by an additional six months before a sale, foreclosure or seizure of the mortgaged real estate can be started.   The new language states that a mortgage holder cannot take action with respect to real property during the period of a servicemember’s military service or within nine months thereafter. 

But that’s not the end of the story. Although this revised provision took effect immediately when the act was signed (July 30, 2008), it will only continue through December 31, 2010. Then, beginning January 1, 2011, the time period will go back to what it was before—in other words, no action with regard to real property during the period of a servicemember’s military service or “within 90 days afterward.”

 2. Longer Interest Reduction

As mentioned above, SCRA’s rule concerning reduction of a loan’s interest rate to 6% has been applicable only while the person remains on active duty. When that person was released from military service, the interest rate immediately increased, as of the date of release, to whatever rate was stated in the promissory note.

This language, set out in Section 207 of SCRA (50 U.S.C. App. 527), has now been partially amended as follows: For mortgage loans, the time period for reduction of the interest rate to 6% will be “during the period of military service and one year thereafter.”  (This change is set out in Section 2203 of HERA).

On mortgage loans, servicemembers will enjoy one more year of interest reduction than they previously received. For loans that are not mortgage loans, there will be no change—in other words, it will continue to be true that the interest rate goes back up from 6% to whatever rate is stated in the promissory note, as soon as the period of active duty ends.

This amendment regarding interest on mortgage loans is permanent. Unlike the other change described above, this one will not change back to what it was before at any future date.

2. Tax Credit for First-Time Homebuyers

The Housing and Economic Recovery Act of 2008 (HERA) also includes provisions enacting a first-time homebuyer tax credit of up to $7,500. Why does this mean to banks? It will bring additional people into the housing market who currently are not homeowners (before July 1, 2009); it will increase the number of homes purchased and the number of mortgages applied for; and it will help buyers to afford the payments related to a home, after they purchase it.

Admittedly, this tax credit was primarily enacted to stimulate home-buying in parts of the country where there are a lot of homes on the market.  However, the tax credit is equally available in Oklahoma, where it is not particularly needed to influence home-buying and actually seems like a windfall.

It should be emphasized that this tax credit is not a government “gift,” but more like an interest-free loan. A taxpayer who receives a $7,500 credit will have to pay that credit back by adding $500 per year to his federal income taxes owed, in each of the following fifteen years. However, compared to an 8% interest rate on a second mortgage in the amount of $7,500 (payable in similar $500 annual principal payments), the repayment of this tax credit over fifteen years saves $4,700 in interest. 

Furthermore, there will be no mortgage against the house for the $7,500 credit amount, so this source of funds does not limit or affect lender-financing on the home.   Once received, the $7,500 credit is not technically a debt owed by the taxpayer, but more like a string of fifteen annual tax payments in the amount of $500 each that the individual will owe. The tax credit will probably not be listed on a borrower’s balance sheet as a liability, nor affect net worth or debt-to-income ratios.

There are some strong advantages to the new “first-time homebuyer” tax credit—and also some disadvantages. (The new statute is codified in Section 36 of the Internal Revenue Code, but was enacted as Section 3011 of HERA.) I will outline the new law’s provisions, and some strategic considerations. (Like all tax provisions, this is somewhat complicated, to avoid potential abuse.)

 1. Structuring a Home Purchase

When borrowers purchasing a first residence aren’t familiar with these provisions, bankers should inform them of what’s available–or send them to an accountant who can help to sort it out. (The statute does not specifically mention “real estate,” so purchasing anything that will become the person’s “principal residence” will apparently satisfy the statute—a house, a condo, a manufactured home, etc. For simplicity I will mostly discuss the subject as if it applies to houses.) Even for borrowers who do not need the tax credit to help finance their home purchase, claiming the credit on a tax return may be too good to pass up.

If a bank is making mortgage loans for its own portfolio with fairly conservative standards—for example, using an internal guideline of 80% loan-to-value—I think the bank might be able to see its way clear to do some “creative financing,” where the pending $7,500 tax credit basically counts toward the otherwise-required 20% down payment. 

A bank could probably structure a transaction that uses either (1) a “side loan” secured by the anticipated tax refund (and other assets, if desired), or (2) a second mortgage loan in the amount of the tax credit. The payment date(s) on the side loan or the second mortgage should roughly match the timetable on which the borrower is expected to enjoy benefits related to the tax credit. 

One approach would be for the borrower to pay all of his federal taxes currently, resulting in a tax refund after the end of the year, equal to the full tax credit amount. (This could be applied to reduce debt.) Alternatively, borrowers who know that they have earned the tax credit (by their home purchase) could reduce the amount of federal income taxes withheld from their payroll each month (using the extra monthly cash flow to make installment payments throughout the year on the “side loan” or second mortgage). Although they might be seriously under-withheld, they would rely on the pending $7,500 tax credit to eliminate their federal income tax liability when their tax return is filed.

Regulatory guidelines generally require a bank to make home mortgage loans on a basis not exceeding 90% LTV, unless there is other credit support. When a bank’s internal standard is more conservative, such as 80% LTV, there certainly is room for the bank to stay within the 90% regulatory limit, while anticipating the future receipt of the tax-credit refund (or extra cash flow from reduced tax withholding during the current year in anticipation of the tax credit) to bring the bank’s position back to 80% LTV within a reasonable time. If circumstances that entitle a borrower to a tax credit are certain, that borrower’s receipt of the tax credit as a source of funds to repay the loan seems fairly secure. Of course, analysis of a borrower’s individual tax situation is necessary to make sure that this and any other tax-refund-based loan will work out as planned.

2. First-Time Homebuyer

The credit is available only to an individual (and, if married, that person’s spouse) who has had “no present ownership interest in a principal residence during the 3-year period ending on the date of purchase of the principal residence to which the [tax credit] applies.”

Although the statute uses the phrase “first-time homebuyer,” what it literally means is someone who has not owned a principal residence for the last three years. (This could be a person of any age who has not recently owned a house, condo, or manufactured home.) In the case of a husband and wife, it must be true that neither one has owned a principal residence in the last three years.

The credit is not available to someone (1) who obtains a mortgage financed with tax-exempt bonds (for example, through the Oklahoma Housing Finance Agency); (2) who is a nonresident alien; or (3) who disposes of the residence (or the residence ceases to be his principal residence–or that of his spouse, if married) before the end of the taxable year in which the property is acquired.

The credit is not available if “the property is . . . acquired from a person related to the person acquiring such property.” (There may be too much opportunity to manipulate the circumstances, if property is transferred from a relative.)

The credit is also not available for property acquired through inheritance, or in a situation where the person acquiring the property takes over the tax basis of the person transferring it.  (In a true “sale,” the buyer has his own tax basis (equal to what he pays for the property), but in some other situations the recipient takes over the tax basis of the one transferring the property—as is true with a gift; a distribution from a trust; or a liquidation of a corporation, LLC or partnership in which the individual has an ownership interest.)  

3. June 30, 2009 Deadline

The credit is available only for “a principal residence purchased by the taxpayer on or after April 9, 2008, and before July 1, 2009.” 

The statute provides a special rule for houses under construction: “A residence which is constructed by the taxpayer shall be treated as purchased by the taxpayer on the date the taxpayer first occupies such residence.”  

This special rule not only expands the group of houses that would be eligible on the front end of the permissible range of dates, but also cuts off some houses on the back end. For example, if a house under construction by the individual was already completed but not yet occupied as of April 8, 2008, it would qualify for the credit based on the date when the owner moved in. On the other end of the required time period, someone constructing a home with the intention of qualifying for the credit could run into unexpected delays (due to weather, materials shortages, building inspections, etc.), with the result that the owners cannot actually move in before July 1, 2009, and in that event the tax credit would be lost.

4. Principal Residence

The ordinary scenario where the tax credit will be used involves a young couple who currently rent a house or apartment, have never owned real estate or a manufactured home, and want to use the tax credit to buy a first residence.   The provisions may also be useful for individuals who have not owed any residence lately (over the past three years). The lack of ownership in recent years could be due to financial or family disruptions—such as divorce, bankruptcy, job relocation, or acting as caregiver for elderly parents—or other reasons.

The tax credit is intended to assist with the purchase of a residence that, in good faith, will become the individual’s real home.   It doesn’t work for a vacation home, cabin, investment property, or other “second home” that will not be the primary place where the person lives. Perhaps an individual doesn’t own any principal residence (for example, because he primarily lives in a home or apartment rented from someone else, or in a relative’s home); but the tax credit still won’t be useful to him as buyer of a property unless he will be primarily living in the purchased property.  

In some cases a person may own a rent house (where he does not live), while living for the past three years in other property that he does not own. (The treatment on his tax returns can help to demonstrate this.) He still may be eligible to buy a real “principal residence,” using the tax credit, because he owned no real estate or manufactured home as his “principal residence” during the past three years.

 5. Amount of Tax Credit

The maximum amount of the tax credit is $7,500—but not to exceed 10% of the purchase price of the principal residence. If the purchase price is less than $75,000, the actual tax credit is reduced to 10% of the purchase price.  (For example, a $25,000 “used” manufactured home qualifies for a $2,500 tax credit.)

This maximum $7,500 tax credit is available to a single individual purchasing a principal residence, or to a married couple purchasing a principal residence and filing a joint return. If a married couple purchasing a home is paying taxes as “married individuals filing separately,” they will each separately be allowed half of the tax credit–up to $3,750. If the buyers are two or more persons who are not married spouses (for example, an unmarried couple, or a parent and adult child), the $7,500 credit will be divided between them in a manner to be determined by IRS regulations.

Caution: The tax credit of $7,500 is fully available, in the case of a single individual (filing separately) if “modified adjusted gross income” (MAGI) does not exceed $75,000 in the particular taxable year (either 2008 or 2009) when the principal residence is purchased. For a married couple filing a joint return, the maximum credit is available only if “modified adjusted gross income” does not exceed $150,000 for that year. 

For a single individual, the amount of tax credit available will phase out proportionately (from $7,500 down to $0) as MAGI rises within the range between $75,000 and $95,000. For married couples filing jointly, phase-out of the credit occurs as MAGI increases from $150,000 to $170,000. 

If a borrower (and lender) are relying on a “first-time homebuyer” tax credit to repay debt, and the borrower’s projected income is near the phase-out range, avoiding unanticipated income in the taxable year when the “principal residence” is purchased (such as capital gains, dividends, commissions, and bonuses) is important to keep the amount of the tax credit from being reduced.

6. “Refundable” Tax Credit

As mentioned above, this tax credit is “refundable.”  It must be applied first against any amount of federal income tax that remains owing and unpaid; but a taxpayer can get a “tax refund” for any part of the credit that exceeds any federal taxes owed. If an individual has completely paid the amount of federal income taxes that he owes for the taxable year in which he purchases a first-time principal residence, he could receive a $7,500 “tax refund” check, equal to the full amount of the tax credit.

The other way around, if an individual fails to withhold enough federal income tax from his payroll, his “first-time homebuyer” tax credit of up to $7,500 may result in a refund that is considerably smaller. (Note that a bank can take a security interest in an anticipated tax refund as a source of repayment of a loan, but cannot be secured in more than the refund turns out to be, after payment of all federal taxes owed. There are also other ways that a federal tax refund can be intercepted before it is paid out—for example, by “offset” to pay other amounts owed to the U.S. Government, or to pay past-due child support.)

When a “refund” of the borrower’s tax credit is being relied on as a significant source of additional cash flow, the lender must be familiar with the borrower’s specific circumstances, including income, amount of tax withholding, amount of projected tax refund, and any legal issues that might cut off that person’s refund. 

7. Accelerated Recapture of Tax Credit

The statute uses the term “recapture” to refer to the required process of repayment of the tax credit.  (The credit is not a gift from the government, but more like an interest-free loan.) Repayment is as follows: In each of the fifteen years after the tax credit is received, an amount equal to six and two-thirds percent of the amount of the credit gets added to the tax owed for that year. With fifteen payments of this amount, the credit is fully repaid.

The statute also contains provisions requiring accelerated recapture of the tax credit (faster than the normal fifteen-year recapture period) in two situations–(1) if the taxpayer disposes of the residence for which the tax credit was received, before the fifteen years are up, or (2) if the residence ceases to be the principal residence of the taxpayer (and, if married, of the taxpayer’s spouse) during the fifteen-year period. 

Accelerated recapture works like this: A taxpayer buys a “principal residence” in 2008, receives a refund of the $7,500 tax credit in 2009 (after filing the tax return for calendar year 2008), and “pays back” $500 per year (along with his federal tax return) in both 2010 and 2011 as normal scheduled “recapture” payments. But in late 2011, the individual sells the house. This causes the remaining thirteen recapture payments to be accelerated. As a result, $6,500 of tax recapture will be added to his federal income tax bill for calendar year 2011 (as reflected on a tax return filed in 2012). 

When federal taxes of any kind become due in a lump sum and cannot be paid, the IRS will add interest and penalties, and can pursue all available tax-collection remedies, including garnishing bank accounts and wages, or filing a tax lien on the individual’s property. Thus, a tax credit that looks very attractive in the right circumstances can be “bad news” in the wrong circumstances—for example, when a taxpayer does not expect to own a principal residence for very long.    

8. “Tax Recapture” Examples

If a first-time homebuyer later sells his principal residence to someone who is related, the full amount of tax-credit “recapture” will become due (any amounts not already repaid to the IRS), ignoring whether the sales price is high or low. 

By contrast (as sort of a “hardship” provision), if the sale of the principal residence is to someone who is not related to the taxpayer, the amount of tax credit “recapture” that the individual is required to pay to the IRS will be reduced to $0 if there is no “gain on sale,” or will be limited to the amount of “gain on sale” if the gain is less than the amount of tax credit not yet repaid to the IRS. 

For “recapture” purposes, the statute calculates “gain on sale” differently than for “capital gains” purposes:   Solely for purposes of “recapture,” a taxpayer’s basis (cost) in the property is reduced by the portion of the total tax credit that has not yet been repaid to the IRS. This “reduced basis” is then compared to the taxpayer’s net sales proceeds, to measure whether there is a “gain on sale.”  The amount of accelerated tax-credit recapture owed because of an early sale of the principal residence cannot be more than the “gain on sale” calculated in this manner.

Assume that a first-time homebuyer buys a principal residence for $100,000 and receives a $7,500 tax credit. After two annual $500 “recapture” installments have been paid to the IRS, the individual sells the house. At this point, $6,500 of tax credit remains unpaid to the IRS. The homebuyer’s original “tax basis” in the house is $100,000; but this basis is reduced (for “recapture” purposes) by the amount of tax credit not yet repaid to the IRS. The taxpayer’s “reduced basis” at the time of sale is $93,500. 

Taking this example further, if net proceeds from sale of the principal residence (net of realtor’s commission and closing costs) are $100,000 or more, there is at least a $6,500 “gain,” and accelerated recapture of tax credit in the amount of $6,500 must be paid to the IRS for the taxable year when the home is sold. If the seller’s net proceeds are $98,000, the tax-credit-related “gain” is $4,500 ($98,000 minus $93,500), which is also the maximum accelerated recapture payable to the IRS. If net proceeds are $93,500 or less, there is no “gain” for this purpose, and the taxpayer owes no recapture to the IRS.

Let’s consider another example: The “first-time homebuyer” purchases a $100,000 house, with a $97,000 first mortgage. Three years later, the property’s appraised value has increased, so the borrower takes out a $10,000 second mortgage (HELOC). Four years after the original purchase, housing prices have declined, but the borrower needs to sell the house because of a job transfer. At that time, the amount of tax credit not yet repaid to the IRS is $6,000. The combined balance of the first and second mortgages is $105,000.   The “reduced basis” of the house (for purposes of this statute) is $94,000 ($100,000 minus the $6,000 portion of tax credit not yet repaid).

After an extended listing on the market and a reduction in price, the home sells for $110,000. The owner pays a 6% realtor’s commission and receives net proceeds of $103,400, which must be supplemented with funds “out of pocket” to satisfy the two mortgages totaling $105,000. Accelerated recapture of $6,000 will also be owed to the IRS, although not at closing.  (As this last example illustrates, it may be good not to borrow additional amounts against the principal residence until the equity is substantial; but a temporary second mortgage that will be paid off by receipt of the tax credit “refund” does not create the same problem.)

 9. Death; Condemnation of Property

If the taxpayer dies before fifteen annual tax credit “recapture” payments are made, no more payments are required. But in the case of a principal residence purchased by a husband and wife filing a joint tax return, the surviving spouse will be treated as having received exactly one-half of the total tax credit, and will continue repaying that one-half. 

For example, a husband and wife receive a $7,500 tax credit, and are required to pay it back by adding $500 annually to their federal income taxes, for each of the next fifteen years. Later, the husband dies, but the wife survives. She will be treated as having received $3,750 of the total tax credit, repayable $250 per year until the fifteen years are up. So together they owed $500 per year; after he dies, the rest of his half is forgiven; and she continues to owe $250 for each of the remaining years.

If a principal residence is “involuntarily converted” (for example, condemned for public use, such as for highway widening; or destroyed by a tornado, fire or flood), that involuntary sale or destruction of the property will not result in acceleration of recapture payments, provided that the homeowner purchases or rebuilds a replacement principal residence within two years. The requirement to make recapture payments, and the schedule of payments, will then apply to the replacement residence as if it were the original residence. A later sale of the replacement residence will result in accelerated recapture of any part of the tax credit that is not yet repaid to the IRS.

10. Divorce; Transfers between Spouses

In a divorce, one of the spouses is granted full ownership of the formerly jointly-owned residence. A court order transferring the “principal residence” to that one person will not be treated as a disposition of the residence by the spouse who has no continuing ownership interest in the residence. (No accelerated recapture of tax credit will result from the divorce, if one of the individuals retains ownership of the residence.)  However, the obligation to continue making recapture payments to the IRS (over a period of fifteen years) will follow the property. (The spouse who gets the property must continue making the full annual recapture payments during the fifteen-year period. A spouse who no longer owns the property will have no continuing liability for those recapture payments.)

Similarly, one spouse sometimes voluntarily deeds a principal residence to the other spouse. The outcome in this situation (for purposes of recapture of tax credit) is the same as described above for a divorce.

11. Requirement to File Tax Returns 

One possible disadvantage in claiming the “first-time homebuyer” tax credit is that the homeowner will be required to file a tax return in any year when a recapture payment is due. (If the homeowner is liable for recapture payments over a period of fifteen years, he must file a federal income tax return for each of those fifteen years.)

Generally, someone with enough income to buy a residence will also have enough income to be required to file a tax return. (Rarely, elderly individuals may have enough savings to buy a “principal residence”—for example, a used manufactured home—although they are not required to file annual tax returns.)

Also, many young couples who otherwise might be able to file an IRS Form 1040EZ, will be required to file Form 1040 to report the annual “recapture” amount owed to the IRS. The cost of paying a tax preparer may be slightly more. 

3. Can Banks Freeze Home-Equity Lines of Credit?

Perhaps you have read news stories recently, indicating that some of the biggest banks in the U.S. are reducing or freezing credit lines on hundreds of thousands of HELOC loans. These articles may not give much detail–but I doubt any bank just “cuts everyone off, across the board.”  Instead, they seem to be acting case-by-case, with respect to specific loans, because of a decline in value of the home securing the loan, and/or because an individual borrower’s finances are deteriorating.  (Lots of loans fit those categories, in some regions of the country.)

Regulators seem to be a bit nervous about this trend, and as a result are reminding banks of the “rules” that must be followed in order to restrict a borrower’s right to obtain further advances under a HELOC. In June the FDIC issued guidance explaining consumer protection provisions that limit how a lender can reduce or suspend a borrower’s access to his line of credit under an existing HELOC. And in August, the Office of Thrift Supervision (OTS) issued its own “Home Equity Line of Credit Account Management Guidance” covering the same subject.

Of course, commercial banks are not subject to OTS regulation; but the FDIC and OTS comments on this subject explain the same federal laws and regulations. I will highlight some provisions from the FDIC’s version, while also quoting the OTS guidance where it provides additional useful information.  

1. Grounds for Reduction

A bank cannot just decide to “freeze” all of its HELOC credit lines (cutting off the borrowers’ right to obtain further advances). This is not an option under Regulation Z. Even in other parts of the country where real estate values have plummeted, a lender needs to consider the particular property’s decline in value or the particular borrower’s declining financial condition, before freezing or reducing that specific person’s HELOC credit line.

Regulation Z generally prohibits lenders from changing HELOC terms, unless the change fits within certain specific exceptions:

A. In one exception (Section 226.5b(f)(3)(vi)(A) of Reg Z), the lender can prohibit additional extensions of credit or reduce the credit limit applicable to the HELOC if “the value of the dwelling that secures the plan declines significantly below the dwelling’s appraised value for purposes of the plan.” The regulation does not define a significant decline in value.

The Federal Reserve’s Commentary to Regulation Z, in note 6 under Paragraph 5b(f)(3)(vi), states that what is a “significant decline” in value can vary according to individual circumstances. It adds, “In any event, if the value of the dwelling declines such that the initial difference between the credit limit and the available equity (based on the property’s appraised value for purposes of the plan) is reduced by 50 percent, this constitutes a significant decline in value. . .” 

The Commentary provides an example: A house has a first mortgage of $50,000 and appraises at $100,000, leaving $50,000 of equity. A second-mortgage lender approves a HELOC for $30,000, leaving a difference of $20,000 between the appraised equity and the amount of the HELOC. Half of the “difference” is $10,000. If the property declines in value from $100,000 to $90,000, half of the “difference” (half of $20,000) has been eliminated. This is a “significant decline” in value and justifies suspending further advances on the credit line.

The Commentary states that the lender does not need to obtain a new appraisal of the specific property in order to determine that a significant decline in value has occurred. The FDIC allows “automated valuation models or local tax assessments” to be used, subject to the limitations on validity of those approaches.

Oklahoma is not seeing an overall decline in property values, although other areas of the country are. For the twelve months ended June 30, homes in Oklahoma actually had the strongest increase in value in any state in the U.S. (just under 5%). 

But there still may be “pockets” of weakness in specific segments of Oklahoma’s real estate market—for example, very expensive homes, lake homes, homes in certain rural areas, or homes in a community where layoffs have occurred.  If a bank can determine that a property’s valuation has “significantly declined,” freezing the HELOC line of credit is allowed.

The FDIC cautions that a lender determining revised property values should have a “sound factual basis” that is “applied consistently.” A lender could engage in discriminatory lending by applying its property revaluation methods inconsistently or in a way that might constitute redlining of certain areas or neighborhoods.

The FDIC suggests (although not required by Regulation Z) that borrowers be allowed a review process, on request, after the lender reduces or suspends a credit line based on a significant decline in a property’s value—particularly if the lender used an automated valuation system. A borrower might be able to provide information to change the lender’s conclusion as to value. (Maybe the borrower has improved the property substantially since the last appraisal, or knows of strong “comparable sales” in the immediate area.)

B. A second exception allows the lender to prohibit additional extensions of credit under a HELOC, or reduce the credit limit, if “the creditor reasonably believes that the consumer will be unable to fulfill the repayment obligations under the plan because of a material change in the consumer’s financial circumstances . . .” Note 7 under Paragraph 5b(f)(3)(vi) of the Reg Z Commentary points out that this provision has two conditions, and both must be present: “First, there must be a ‘material change’ in the consumer’s financial circumstances, such as a significant decrease in the consumer’s income. Second, as a result of this change, the creditor must have a reasonable belief that the consumer will be unable to fulfill the payment obligations of the plan.”

A lender might lack clear information about the borrower’s continuing ability to make payments on the HELOC—especially while payments on the HELOC remain reasonably current. The Commentary allows the lender to infer from the consumer’s failure to pay other debts that the borrower will be unable to continue making the payments as required under the HELOC.  

Regulation Z imposes a “reasonable belief” standard on the lender in this situation. The FDIC notes that the lender needs a “factual basis” for any actions taken under this provision–and the factual basis “should be determined consistently, to avoid the risk of prohibited discrimination or unfair practice.”  

For existing loans any lender can obtain credit reports on a regular basis to evaluate the borrower’s financial condition. Based on information from a credit report, a lender might suspend or reduce the borrower’s right to obtain additional advances on a HELOC. Whenever a lender takes adverse action (here, cutting off a credit line) based on information in a credit report, the Fair Credit Reporting Act requires the borrower to provide an adverse action notice to the borrower.

C. In a third exception, Section 226.5b(f)(3)(vi)(C) of Reg Z allows a lender to cut off or reduce the borrower’s right to obtain further advances under the HELOC if “the consumer is in default of any material obligation under the agreement . . .” As the OTS points out, a lender can require that the property remain owner-occupied; and when the borrower moves out of the dwelling, there is a material default under the HELOC. As another “material” example, an “intervening lien” could be filed “that would take priority over future advances.” (A federal tax lien would fit this provision.  The lien of past-due real estate taxes is another example.)

2. Notice of Reduction

When a lender cuts off additional advances under a HELOC, or reduces the available credit limit, Section 226.9(c)(3) of Reg Z requires a written notice to be mailed or delivered to each consumer who will be affected. This notice must be provided within three business days after the action is taken and must contain specific reasons for the action.

3. Periodic Re-evaluation

Regulation Z also may require a lender to restore a frozen or reduced HELOC credit line if circumstances change. Note 2 to Paragraph 5b(f)(3)(vi) of the Fed’s Reg Z Commentary states, “Creditors are permitted to prohibit additional extensions of credit or reduce the credit limit only while one of the designated circumstances exists. When the circumstance justifying the creditor’s action ceases to exist, credit privileges must be reinstated, assuming that no other circumstance permitting such action exists at that time.” 

The OTS outlines two permitted approaches to this situation: “One way [to] meet this responsibility is by monitoring an affected line of credit frequently enough to assure . . . that the condition permitting the suspension or reduction continues to exist.” (Note 4 to Paragraph 5b(f)(3)(vi) of the Reg Z Commentary.) The other approach is to “require borrowers to request reinstatement of credit privileges” when they believe the situation has changed sufficiently. They can notify the lender that a review of the circumstances is in order, as set out in Section 226.9(c)(3) of Reg Z.

If the lender uses the second approach, it only has a duty to re-evaluate the situation when the consumer requests. However, once the consumer makes such a request, “the creditor must promptly investigate to determine whether the condition allowing the freeze continues to exist.” (Note 4 to Paragraph 5b(f)(3)(vi).) 

4. Best Practices

The FDIC urges lenders to work with borrowers “who may experience financial hardship or significant inconvenience as a result of a reduction or suspension to their credit limits” under a HELOC.

FDIC notes that borrowers may be especially inconvenienced if they use a HELOC “to fund home improvements in progress, as cash management tools, or to finance small businesses.”  (Someone might have a major kitchen remodel underway, with a binding obligation to a contractor; or could be financing the start-up of his small business with advances on his HELOC because the lender preferred that collateral or offered a better rate; or might have an extremely seasonal income pattern, using borrowing during the “slow” season to meet living expenses.)

The FDIC suggests that when a lender reduces or freezes a HELOC credit line (depending on the borrower’s creditworthiness and overall financial circumstances), “it may be possible to offer alternative types of credit or other arrangements to mitigate the negative effects of credit line reductions or suspensions.”

The FDIC is maybe suggesting that a bank take the same “flexible” approach to an inadequately secured consumer line of credit (HELOC) that it takes with commercial or agricultural lines of credit. (With a commercial customer, a bank changes or increases collateral when necessary, and often arranges a combination of loans that protect the bank’s interest while also meeting the borrower’s changing needs and circumstances.) Instead of looking only at whether the borrower’s right to obtain continuing advances on a HELOC should be cut off, a lender should also consider whether other available loan products could help the borrower.  This is particularly true when collateral value, not net income or payment history, is the problem under the HELOC.  The FDIC notes that flexibility or innovation of this type may be favorably evaluated in a CRA examination.