Thursday, August 18, 2022

May 2009 Legal Briefs

Charging Consumer Interest Using a 360-Day Year?

Adding a Floor to Variable-Rate Mortgage Loans?

Waiving a Rate That is Too High

Default Interest Not Allowed on Consumer Loans?
 

    

Charging Consumer Interest Using a 360-Day Year?

 We continue to receive questions, year after year, concerning whether a bank can charge interest on consumer loans on a 360-day basis.  (A lender might disclose, for example, that the borrower will be charged an 8% interest rate based on a 360-day year.  Actually, a lender charges 365/360 of that amount on a full-year basis, or approximately 8.11% interest annually.) 

 It is a common practice with commercial loans to provide that interest will be owed on a 360-day basis.  This practice is not wrong or illegal for commercial loans.  (No specific provision regulates how interest charges on a commercial loan must be disclosed. There is no requirement to calculate or disclose an “APR” at all on these loans.  Instead, whatever the borrower and lender agree to is what will apply.)

 The situation is quite different for consumer loans.  Regulation Z requires lenders to make loan disclosures on an “apples to apples” basis, so that consumers can easily compare rates.  This approach also prevents a lender from making disclosures in a deceptive (or less than forthright) way so that a loan will sound better than it really is, or better than what other lenders are offering.

 For closed-end loans, Section 226.18(d) of Reg Z requires a lender to disclose “the annual percentage rate” (APR), using that term. This means “the cost of your credit as a yearly rate.”  The requirement to give a “yearly” rate means the rate for one year, not for 360 days. 

 Section 226.22(a) requires the “annual percentage rate” to be determined “in accordance with either the actuarial method or the United States Rule method.”  This section cross-references Appendix J of Reg Z for calculating the actuarial method.

 Section (b)(1) of Appendix J says the APR shall be determined “by multiplying the unit-period rate by the number of unit periods in a year.” Section (b)(5)(iv) states, “If the unit period is a day, the number of unit periods per year shall be 365.”  Or, if the unit period is considered to be one year, the yearly rate would apply, and would be multiplied by one.  For closed-end consumer loans, calculating an APR will require that an interest rate expressed on a 360-day basis be converted to a 365-day basis.

 Furthermore, Section 226.17(a) of Reg Z requires the terms “finance charge” and “annual percentage rate” to be disclosed in a manner “more conspicuous than any other disclosure except the creditor’s identity.”  Disclosing a consumer loan’s interest rate on a 360-day basis is not prohibited, but that rate must be converted to an APR (365-day rate), and the 365-day APR (as recalculated) must be disclosed more prominently than the 360-day rate.  Failure to do this would be a disclosure violation.

 Generally, disclosing interest on a 360-day basis (for example, on a commercial loan), has no point except to make the rate sound somewhat better than the rate the lender actually wants to collect.  When Reg Z requires the APR (365-day rate) to be disclosed more conspicuously for a consumer loan than any other rate, that becomes the only rate that matters. 

 Using the example first given above, an interest rate of 8% certainly sounds better than 8.11%.  However, for a consumer loan, once an 8.11% APR is required to be disclosed more conspicuously than the 8% 360-day rate, there’s no way that the latter rate can “look better” than it really is. 

 It’s not “forbidden” to disclose a 360-day interest rate in connection with a consumer loan.  But disclosures can’t stop there.  No matter what other information is provided, the lender must calculate and disclose the applicable APR (365-day rate) in a way that is more prominent.  This disclosure might be satisfied by a larger font or bolder print, compared to what is used for a stated 360-day rate.  But here’s the real problem:  A lender’s forms system may not be designed to allow disclosure of both a 360-day rate and an APR in the required manner (and probably won’t have a way to calculate an APR correctly if a 360-day rate is entered).  In short, attempting to use the “360-day-rate” approach can result in disclosure violations (and liability).

  Beyond Section 226.18’s general disclosure requirements in originating a loan, Section 226.24 has advertising requirements for closed-end loans.  This states that any advertisement of the rate of finance charge must be an “annual percentage rate,” using that term, and must be disclosed “clearly and conspicuously.” 

 Section 226.24(c) provides that an advertisement “shall not state any other rate, except that a simple annual rate that is applied to an unpaid balance may be stated in conjunction with, but not more conspicuously than, the annual percentage rate.” I understand these requirements to mean that a lender cannot advertise a 360-day rate at all in connection with a consumer loan, although a 365-day simple interest rate can be advertised (as a second disclosure) if different from the advertised APR.  (If the finance charge includes not only the simple annual rate but also other charges, the lender can advertise both the 365-day simple interest rate and the APR.)  A plan to advertise a 360-day interest rate on a consumer loan (to make the rate look better) won’t work, and apparently will create disclosure violations under Regulation Z.

 My bottom-line advice is this:  If you get the urge to use a 360-day interest rate on consumer loans, don’t do it.  Disclosing it as Reg Z requires will gain you no advantage; but failing to disclose the rate in compliance with Reg Z can create serious disclosure violations.

Adding a Floor to Variable-Rate Mortgage Loans?

The Federal Reserve has taken a variety of steps to reduce interest rates to artificially low levels (the lowest rates in fifty years), including very cheap rates for consumer mortgage loans.  Typically, a bank’s variable-rate consumer mortgage loans are tied to some “objective” national index, because of Regulation Z disclosure requirements.  (By contrast, a bank’s variable-rate commercial loans are often adjustable at the bank’s discretion based on the bank’s own local cost of funds.)  Depending on the manner in which existing variable-rate mortgage provisions are written, the Fed’s artificial tinkering with rates and indexes has in some cases resulted in an uncomfortable decrease in the bank’s interest-rate “spread.”

Some banks are complaining (accurately) that their variable-rate loans have already adjusted lower than the bank would like to see as a minimum rate.  These same banks have never placed a “floor” or minimum rate in their variable-rate loans—partly because they never anticipated that rates could drop as far as they have.

 Section 226.19 of Regulation Z, applicable to mortgage transactions subject to RESPA that are secured by a consumer’s principal dwelling (other than HELOCs), lists certain good-faith estimate (GFE) disclosures that the lender must give before consummation, or within three business days after receiving a written loan application, whichever is earlier. These provisions clearly allow a “floor” or a “cap” (or both) on interest rates in a variable-rate mortgage—but such a provision must be set out in the loan documents at origination, and accurately described to the consumer. 

 Following are some of the provisions required to be disclosed (if applicable) for a variable-rate loan, as listed in Section 226.29(b)(2):
 
 “(i) The fact that the interest rate . . .  can change.
 “(ii) The index or formula used in making adjustments, and a source of information about the index or formula.
 “(iii) An explanation of how the interest rate and payment will be determined, including an explanation of how the index is adjusted, such as by the addition of a margin . . .
 “(vi) The frequency of interest-rate and payment changes.
 “(vii) Any rules relating to change in the index, interest rate, payment amount, and outstanding loan balance including, for example, an explanation of interest-rate or payment limitations . . .”

 As this last sentence suggests, any “floor” that operates as a minimum rate on the loan, or any “cap” on the maximum rate to which a loan can adjust (if either provision applies) must be disclosed by the lender as part of the GFE.

 Paragraph 19(b)(2)(vii) of the Fed’s Commentary to Section 226.19 of Reg Z re-emphasizes this point: “Rate and payment caps.  The creditor must disclose limits on changes (increases or decreases) in the interest rate or payment.”  From a compliance standpoint, there is no “cap” or “ceiling” on how much the interest rate can adjust, unless the GFE disclosures say so.

  Many regional or national mortgage originators offer mortgage loans that limit the amount of rate adjustment per year (for example, not to exceed one percent or two percent per year, up or down).  Some mortgages also include life-of-the-loan limits, so that adjustments cannot exceed a total percentage (for example, no more than a total of five percent, up or down, over the life of the loan).  Provisions like this are a trade-off, shifting part of the interest-rate risk, or sharing that risk, between the borrower and lender.

 A variety of provisions are possible in such mortgages, depending on how much protection the lender wants, and what features the lender believes will help it to be competitive in the market.  Inserting a “floor” in a variable-rate mortgage (for example, providing that the rate can never be lower than five percent), without any other special provisions, is easy to do.  Whatever the loan provides must be accurately disclosed. 

           The Federal Reserve has taken a variety of steps to reduce interest rates to artificially low levels (the lowest rates in fifty years), including very cheap rates for consumer mortgage loans. Typically, a bank’s variable-rate consumer mortgage loans are tied to some “objective” national index, because of Regulation Z disclosure requirements. (By contrast, a bank’s variable-rate commercial loans are often adjustable at the bank’s discretion based on the bank’s own local cost of funds.) Depending on the manner in which existing variable-rate mortgage provisions are written, the Fed’s artificial tinkering with rates and indexes has in some cases resulted in an uncomfortable decrease in the bank’s interest-rate “spread.”

Several banks have been asking, “How can I add a minimum rate or floor, now, to mortgages already outstanding?”  The answer is, “You can’t, unless you have some opportunity to amend the note and mortgage.”  For example, when a variable-rate loan comes due in a balloon payment, the borrower will need an extension or renewal. At that time the bank can ask the borrower to agree in writing to other amendments,  such as a “floor” on the interest rate.

 As another example, if a borrower runs into some cash-flow problems and needs to skip two payments by doing a deferral, the bank can use that opportunity to add a “floor” to the loan’s variable-rate formula.  Similarly, when a borrower is consolidating two loans, or wants to re-amortize his loan over a longer period in order to reduce the payments, the bank can insert a “floor” on the interest rate at that time.

 Reworking an existing mortgage loan (by deferral, extension, or amendment, but without cancelling and releasing the original documents) is technically not a “refinancing” within the meaning of Regulation Z.  Therefore, new Reg Z disclosures are not technically required—although accurate disclosure concerning what a borrower is signing is always appropriate. 

 Going forward, a bank may decide that it wants to insert a “floor” in all of its variable rate loans as they are originated. 

 
Waiving a Rate That is Too High 

 During the past year, some bankers have contacted us with a somewhat opposite problem:  A good customer has a fixed-rate loan, at a rate that originally was acceptable.  Now, because interest rates have dropped so low, he thinks he is being taken advantage of.  (Of course, he would not complain if rates increased and he had a fixed-rate loan.  He only complains because rates have decreased and he has a fixed-rate loan.)  He is threatening to refinance the loan at another bank unless something is done.

 A lot of banks have simply rewritten their loans in this situation.  As explained below, that may be more work than necessary to solve the problem.  Also, offering to decrease the interest rate for the life of the loan may be overly generous—particularly if rates increase later—and that may also be more than it takes to satisfy the customer.  

 Where the only thing necessary is to decrease the loan’s existing fixed rate, it is easy for the bank to make that happen.  The bank can simply give the customer a written partial waiver.  For example, by letter the bank can state that in consideration for the customer’s stated willingness not to refinance the loan elsewhere, for the next six months or twelve months (insert a time period) the bank agrees not to accrue interest on Loan #1234 at a rate exceeding (six percent, for example).  To clarify or expand on this further, the bank can also state that during that period of time the difference between the lower rate that is stated (six percent?) and the rate provided in the promissory note (for example, eight percent) will be waived by the bank. 

 If it’s appropriate to do the same thing again at the end of the stated time period, the bank can provide another partial interest waiver for another period.  When the waivers eventually run out (for example, if interest rates go back up), the terms of the original note will still remain in effect, and can be applied again, going forward, because they have not been permanently modified.  In the meanwhile, no formal amendment is necessary to lower the rate, no fees are charged to the customer for reworking the loan, no change in public filings is necessary, etc.  

Default Interest Not Allowed on Consumer Loans?

 We have received a lot of questions concerning whether a bank can charge a default interest rate or a post-maturity interest rate (higher than the “regular” rate) on closed-end consumer loans.  (The short answer is “maybe,” but this is not allowed in many cases–because of specific provisions in Oklahoma’s Uniform Consumer Credit Code (U3C) and Federal Reserve Regulation Z, which I will discuss below.)

 On certain categories of consumer real estate loans (which I outline), as well as on all non-real-estate consumer loans over $45,000, charging a default rate may be possible.  For other consumer loans, it’s not allowed.

 (Some banks have asked to see “in black and white” the provisions that permit or prohibit charging a “default rate.”  I will explain all of that below, but the answer is more complex than you might like.  In order to charge a default rate “where legal,” it’s necessary to understand how several definitions and exclusions operate in relation to each other.  It may be easier to forget the idea altogether, than to train loan officers to work through the various provisions accurately.) 

 Each individual bank has to make a “business decision” (not a legal decision) whether it’s useful or even desirable to charge a default rate on those specific categories of consumer loans where it’s allowed to do so.  In some cases, a default rate may cause bad “customer relations,” or may be too confusing to administer. 

1. U3C Restrictions

 Section 3-405 of the Uniform Consumer Credit Code states, “Except for reasonable expenses incurred in realizing on a security interest, the agreement with respect to a consumer loan may not provide for charges as a result of default by the debtor other than those authorized by this act.  A provision in violation of this section is unenforceable.”

 This language specifically allows a lender to charge for the reasonable expenses of repossession or sale of collateral—after default.  This statute allows the lender to impose other charges after default if some provision of the U3C clearly permits those other charges.  (An add-on fee or increased fee of any kind, applicable after default, cannot be charged unless the fee is specifically authorized by some other U3C provision.) 

 One fee specifically authorized after default is the attorney’s fee for collection, permitted by Section 3-404 (up to 15% of the unpaid balance of the loan).  The general “late fee” provision, in Section 3-203, is another example of a fee explicitly allowed after default. 
  
 Section 3-208 is another example.  It permits “advances to perform covenants of the debtor.”  (The lender pays real estate taxes if the borrower fails to do so, or force-places required insurance coverage, charging the amounts to the borrower—and this is allowed either before or after default.)

 As to whether a (higher) default rate of interest can be charged, no provision in the U3C specifically allows it.  Accordingly, based on Section 3-405, a default rate is not permitted on consumer loans unless those loans are somehow exempt from the U3C’s restrictions on rates and fees.  (For certain limited categories of consumer loans, the U3C’s restrictions do not apply, as outlined below.) 

2.  U3C & Regulation Z Exceptions

 Certain consumer-purpose loans fall within “exceptions” to the U3C’s coverage.  Loans within these exceptions are generally not subject to various U3C (state-law) restrictions on rates, fees, and practices (including the U3C’s general prohibition on charging a “default” rate of interest).  I will review each of the U3C exceptions, and also similar exceptions available under Regulation Z:

 (a) Certain Loans above $45,000.  The definition of “consumer loan” in Section 3-104 of the U3C does not include a loan originated with a principal balance exceeding $45,000 if the loan is not secured by an interest in land.  Any non-real-estate (and non-dwelling) loan over $45,000 (an expensive car loan, a boat loan, an RV loan, etc.) will drop out of the U3C completely–although the loan is “consumer-purpose.” 

 On this basis, nothing in the U3C would disallow a “default” rate of interest on consumer-purpose non-real-estate loans over $45,000. (The same is true for “dealer paper” over $45,000.)  However, loans on expensive cars and boats are often made to a bank’s best customers.  Inserting a “default interest rate” into these loans may be unnecessary, based on credit quality—and could offend the credit-savvy borrower.  

 Regulation Z has a somewhat similar exemption:  Section 226.3(b) of Reg Z exempts from its provisions any “credit over $25,000 not secured by real estate or a dwelling.” 

 Note one important difference between this language and the U3C exemption:  A manufactured-home loan greater than $45,000 is exempt from the U3C’s definition of “consumer loan”; but it still involves a “dwelling” (although not real estate) within the meaning of Regulation Z, so it’s still a consumer loan for Reg Z purposes.  A loan on a double-wide manufactured home (mobile home) can easily exceed $45,000.  This loan is not a U3C “consumer loan,” but is still a Regulation Z “consumer loan” secured by a “dwelling.”  (This is an example of how complex it can be to understand somewhat conflicting state and federal provisions.  A bank might decide it is easier to forget about charging a “default rate” than to sort this out in all cases.) 

 (b) Certain Real Estate Loans.  In today’s lower-interest-rate environment, two exclusions in Oklahoma’s U3C (discussed below) have the effect of exempting many consumer-purpose real estate loans from the U3C’s coverage, except with respect to disclosures (Section 3-301) and debtors’ remedies (Section 5-201).  (Warning:  Federal provisions, including Regulation Z, may still apply to real estate loans exempted from the U3C.  A lender should also remember that certain “high rate/high fee” mortgages are subject to special restrictions that do not affect more moderately priced mortgages.  It is necessary to consider both the U3C and Regulation Z requirements, before concluding that neither set of provisions applies to a particular real estate loan.) 

 Many “restrictions on practices” contained in the U3C are neither “disclosures” nor “remedies,” and will not apply to consumer-purpose real estate loans falling within two excluded categories explained below.  (Provisions regarding “default rate,” maximum allowable “late fee,” the general 21% interest-rate cap on consumer loans, and the prohibition on “balloon payments,” are all analyzed in the same way, and will not apply to a consumer loan falling outside of the U3C’s coverage based on the two real-estate-loan exclusions below.)

 (1)  Loan to build or purchase a residence.  Section 1-202(5) of the U3C generally exempts from the U3C’s coverage those loans “made to enable the debtor to build or purchase a residence or to refinance such loan.  Provided, however, the U3C provisions with respect to (a) disclosures and (b) remedies will still apply, and also (c) the general 45% usury rate for all loans not otherwise limited by the U3C.

 Relying on this particular exclusion is useful mainly for loans made to “build or purchase a residence.”  (The “refinance” portion of this language may be deceptive if one assumes too much about what it covers.  In order for a loan to count as a “refinance” within the meaning of this section, every dollar of the “refinanced” principal balance must trace back to the principal balance outstanding on the “purchase” loan immediately prior to the refinance.  If a new loan cashes out additional equity in the residence or rolls “new” closing costs into the principal balance, it cannot be counted as a “refinancing” of the old loan with the meaning of this provision.)

 A loan meeting this test can have any priority—first or second mortgage–as long as the principal balance represents funds to purchase or build the residence.  Loans can fit this category without regard to interest rate, and can be either fixed or variable.  A closed-end second mortgage loan might be a “loan to build or purchase,” but a HELOC (with repayments and new advances) cannot be.

 (The official Oklahoma Comment to Section 1-202(5) observes that in 1982 the statute deleted the word “mortgage,” so that a loan to purchase a mobile home as a residence would qualify under this exemption.  The U3C does not define what is a “residence.”)

 The primary purpose for the Section 1-202(5) exclusion was to avoid restricting the free flow of mortgage financing provided by secondary-market investors, mainly from out of state.  (These investors can easily purchase mortgages elsewhere if Oklahoma’s provisions are too onerous.)  Mortgages intended for sale into the secondary market are mostly on standard terms required by a government-sponsored entity (GSE) such as FHA, FNMA, or GNMA.  Even when a bank intends to retain the loan for its own portfolio, use of the GSE’s form will enhance the bank’s ability to sell the loan later if circumstances change.

 This exclusion from U3C restrictions is primarily intended to defer to GSE mortgage-origination requirements, and is not so much to create a wide-open category where no rules apply.  Nevertheless, the exclusion for consumer mortgage loans made to “build or purchase” is available whether the mortgage will be resold or not—and banks originating mortgage loans for their own portfolio can benefit from it.

  I’ve established that a “default rate” may be generally legal in this case (see more discussion below), but some good arguments remain for not putting a “default rate” provision in a consumer mortgage originated to “build or purchase.”  For example:

 • A “default rate” provision (which violates GSE guidelines) will probably make a consumer mortgage ineligible for sale into the secondary market (if a bank later changes its original intention and sells that mortgage).  When originating fully-amortizing mortgage loans to “build or purchase” (usually with an adjustable rate,  because of the maturity), banks often use nationally standard forms (FHA, FNMA) to preserve the bank’s options—and these forms cannot include a “default rate.”

 • Historically, home mortgage origination has been highly competitive, with many sources available.  For a borrower with good credit, competition among lenders is strong.  The borrower may simply go elsewhere if the lender tries to insert provisions (such as a “default rate”) that the borrower finds unattractive.  For this reason, banks have usually not inserted a “default rate” provision in consumer mortgages, even where allowed.  For certain “high-cost/high-fee” mortgages (for borrowers with lower credit scores, who have fewer lending options available), both the U3C and Regulation Z prohibit using a “default rate” at all, as discussed below.

 (2) Loan primarily secured by an interest in land, with a rate not exceeding 13%.  The second U3C exclusion, in Section 3-105, is for any loan that is “primarily secured by an interest in land,” if (a) the value of the land is substantial in relation to the amount of the loan (in other words, it’s primarily a real estate loan, even if other collateral is pledged), and also (b) “the loan does not exceed thirteen percent (13%) per year calculated according to the actuarial method . . .”  

  This exclusion partially overlaps the first exclusion, but is also available for certain loans not fitting the “build or purchase” exclusion, above.  To fit within this second exclusion the loan should either be fixed-rate (not exceeding 13%) or adjustable-rate, but capped at no more than 13%.  (Many “balloon-payment” mortgage loans are fixed-rate through their stated maturity, and do not exceed a 13% rate.)

 (In 1982, what had previously been a 10% limit in Section 3-105 was raised to 13%.  In 1981, the prime rate had reached 21.5%.  At that time a mortgage with a rate of up to 13% was attractive, and unlikely to include abusive lending provisions, so further regulation was not required.  Under current lending conditions “normal” rates are substantially lower.  The 13% rate in Section 3-105 has not changed, but separate provisions in the U3C and Regulation Z also measure rate-appropriateness in relation to U.S. Treasury rates for comparable maturities.   At the present time, a mortgage that fits within the 13% rate limit could still be considered “high-rate” based on other provisions in the U3C and Regulation Z (discussed later).  If so, those other provisions would prohibit including a “default rate” in the mortgage.  As this illustrates, and depending on the circumstances, exclusions in the U3C can be cut away by other provisions that add back certain restrictions. )

 In contrast to the first U3C exclusion, the one in section 3-105 does not require the mortgaged real estate to be a “residence.”  Any real estate will do.  A loan under discussion will presumably be “consumer-purpose” (or we wouldn’t be looking at U3C exclusions), but the real estate fitting this test might be an undeveloped lot, or other real estate with a use that is agricultural, commercial, office, residential, etc. 

 For example, a lender might originate a three-year or five-year fixed-rate mortgage loan (13% or less) to finance the purchase of an expensive residential building lot.  If the consumer has no plans to build until this loan is paid off, it’s not a loan to “build or purchase” within the first U3C exclusion, but it’s still a consumer-purpose loan that is primarily secured by real estate, under the second U3C exclusion.

 As another example, someone might obtain a fixed-rate closed-end second mortgage loan to remodel a residence that is already owned.  This loan is not to “build or purchase” (the first exclusion), but still fits the second exclusion (primarily secured by real estate) if the rate does not exceed 13%.

 In another case, a “refinance” of what was originally a loan to “build or purchase” might cash out some additional equity in the residence.  If not all of the new loan’s proceeds can be traced back to dollars owed on the loan to “build or purchase,” this loan (primarily secured by real estate) will not fit the first exclusion; but with a rate not exceeding 13%, it does fit the second exclusion. 

3.  No Exclusions for High-Rate/High-Fee Mortgages

 As mentioned above, the general exclusions from the U3C’s prohibition on charging a “default rate” are reversed by both Reg Z and the U3C if a particular category of mortgages meets either a “high-rate” or “high-fee” definition.  To summarize in simplest terms, a “default rate” may be allowable in a consumer mortgage if the loan does not have an expensive interest rate or high closing costs to begin with; but if the basic loan pricing is expensive (“high-rate” or “high-fee”), a “default rate” will generally not be allowed for that loan.

 a. Regulation Z Restrictions.  Regulation Z, at Section 226.32(d)(4)—a HOEPA provision—prohibits “an increase in the interest rate after default” for any consumer loan secured by the consumer’s principal dwelling if that loan falls within the “high-rate/high-fee” categories described in Section 226.32(a)(1)—although three loan categories are not covered by this at all–“residential mortgage transactions,” reverse-mortgage transactions, and open-end credit plans.  If a bank wants to charge a “default rate,” it must be careful that the loan is not a “high-rate/high-fee” mortgage. 

 (The same Reg Z/HOEPA provisions that apply to “high-rate/high-fee” loans (with exclusions) to forbid a “default rate” also prohibit other features in such loans:  (1) balloon payments, (2) negative amortization, (3) pre-payment penalties that would continue to apply more than two years following origination, and (4) due-on-demand clauses.)

 As defined in Section 226.2(a)(24) of Reg Z, a “residential mortgage transaction” is “a transaction in which a mortgage, deed of trust, purchase money security interest arising under an installment sales contract, or equivalent consensual security interest is created or retained in the consumer’s principal dwelling to finance the acquisition or initial construction of that dwelling.”  This is a “purchase or build” exception similar to what appears in the U3C. 

 Section 226.32(a)(1) defines what interest-rate pricing or closing-fee pricing on closed-end loans on a principal dwelling (other than excluded loans) is considered “high-rate/high-fee.”  (Meeting either the “high-fee” test or the “high-rate” test will bring applicable loans within this section’s restrictions.) 

 A loan is “high-fee” if “total points and fees [as defined in Section 226.32(b)(2)] payable by the consumer at or before loan closing will exceed the greater of  8 percent of the total loan amount, or [$583—as last adjusted annually effective January 1, 2009].” 

 Section 226.32(a)(1)(i) provides that a loan is “high-rate” if “the annual percentage rate at consummation will exceed by more than 8 percentage points for first-lien loans, or by more than 10 percentage points for subordinate-lien loans, the yield on Treasury securities having comparable periods of maturity to the loan maturity as of the 15th day of the month immediately preceding the month in which the application for the extension of credit is received by the creditor.” 

 (Effective October 1, 2009, based on 2008 amendments to Regulation Z located in Section 226.35, certain additional restrictions apply to loans that the Federal Reserve defines as “higher-priced.”  Generally, all loans that are “high-rate/high fee” under Section 226.32 will fall within the separate “higher-priced” category.  However, the “higher-priced” category is broader.  Unlike the “high-rate/high-fee” category, it also includes loans made to purchase a residence, provided that those loans are not bridge loans and are not to finance the original construction.  Although this new “higher-priced” category prohibits the inclusion of certain terms in covered loans, a “default rate”  is not among them. Therefore, I will not discuss this category further.)

 b. Similar U3C Restrictions.  Oklahoma’s U3C has its own state-law version of HOEPA’s “high-rate/high-fee” restrictions.  Title 14A, Oklahoma Statutes, Section 1-301(10), describes such loans as “Subsection 10 mortgages.”  The definition is similar (with similar exclusions), applying to (1) loans priced more than 8% over the Treasury rate for comparable maturities (for first-lien loans), or more than 10% over the Treasury rate (for subordinate-lien loans), or (2) loans with “total points and fees payable by the consumer at or before closing [that] exceed the greater of: (aa) eight percent (8%) of the total loan amount; or (bb) [$583—as last adjusted annually effective January 1, 2009].”

 Section 1-301(10) defines the term “Subsection 10 mortgage” as “a consumer credit transaction that is secured by the consumer’s principal dwelling” (using the word “secured,” and not the word “mortgage”).  This definition appears to include loans on manufactured homes that are a “principal dwelling”—even though the collateral is personal property, and lender’s interest is not collateralized by a real estate mortgage.   Like Section 226.32 of Regulation Z, the term “Subsection 10 mortgage” is defined to exclude three loan categories—(1) a “residential mortgage transaction,” (2) a “reverse mortgage transaction,” and (3) “a transaction under an open-end plan.” 

 Just as Section 226.32(d) of Reg Z provides, with respect to the loans that it covers, the U3C at Section 3-309.4 states that a Subsection 10 mortgage “may not provide for an interest rate applicable after default that is higher than the interest rate that applies before default.”  

4. Further Considerations.

 A “default interest rate” is often found in commercial real estate mortgages and other commercial loans, for a variety of reasons:  (1) There is no prohibition on including such terms in commercial loans.  (2) Provisions that might be considered “harsh” in consumer loans are left unregulated in commercial loans because commercial borrowers are generally more sophisticated, and better able to understand what they are signing—and often have more leverage to re-negotiate provisions that they don’t find acceptable. (3) Commercial loans are larger–meaning that a default on such loans can be more detrimental to a lender.  To some extent, a “default rate” may help to focus a commercial borrower on making timely payments to the bank instead of diverting funds to pay other bills. (4) Collateral pledged on a commercial loan (whether it’s real estate, equipment, inventory, etc.) is often of a larger size or has a specialized purpose, making it harder (requiring longer) to sell. When more time will be required between (a) the borrower’s default and (b) the point when proceeds of sale of the collateral can be applied to reduce the debt, it may be more important to a bank to be able to charge the default rate on the loan balance during that interim period.  (5) Including a “default rate” in the commercial loan’s terms basically assumes that in a default the bank will be able to collect not only the principal balance and accrued interest, but also something more–“default” interest.  Commercial loans typically involve a lower maximum loan-to-value ratio; and on this basis, for a properly-underwritten commercial loan, may actually have a good chance of collecting the “extra” interest that accrues by using a default rate.   
 
  However, in contrast to commercial loans, the assumptions on which consumer loans are made may be very different.  In considering whether to include a “default rate” in a consumer loan, the first issue (already discussed) should be whether such a provision is even legal under the circumstances.  To summarize what I have already stated above, it will probably only be legal (1) on consumer non-real-estate loans above $45,000, (2) on certain categories (but not all types) of consumer real estate mortgages, and (3) on loans to acquire other types of non-real-estate “primary residences” (that is, mobile homes).

 When a lender has determined that a “default rate” will be legal on a particular type of consumer-purpose loan, a variety of other questions may be relevant to the bank’s decision whether to include such a provision:

 a. Is the collateral of a type (such as a vehicle) that typically can be repossessed and sold quickly, without court action?  If so, there may be little point in imposing a default rate, because not much extra interest can accrue during a relatively brief period of time before the collateral is sold.

 b. Similarly, is the loan (regardless of collateral) for a rather small amount?  If so, the same reasoning applies—not much extra interest can accrue, and inserting such a provision is probably not worth it.  In relative terms, even consumer real estate loans are usually substantially smaller than commercial loans, so there’s “less to gain.”  A lender should decide what categories of loan are important enough to include a default rate, from a standpoint of additional potential income. 

 c. Will the borrower be good for the charges, if a default rate is imposed? 
Most consumer loans go into default because (under the particular circumstances) the borrower doesn’t have enough money to make the payments.   If we consider the scenario where the borrower can’t afford to pay, is a bank just “kidding itself” when it inserts a default-rate provision that the broke consumer also can’t afford?  The answer may depend on the loan’s collateral coverage, but consumer loans typically have a higher loan-to-value ratio.  Depending on the situation, there may not be much “extra” collateral available to go after by providing for “extra” charges.

 d. Do other banks impose a “default rate” on this type of loan?  The answer may be “probably not.”  And how sensitive are consumers in this category to the inclusion of a “default rate” in their loans?  That issue matters, because it’s probably not worth it if including this provision would motivate a consumer to go to another bank.   On non-real-estate consumer-purpose loans above $45,000 (such as a loan on an expensive car), the borrower may be a higher-income individual who is very alert to borrowing costs, and he might easily be offended by such a provision.

 e. Would this type of collateral take longer to liquidate?  This analysis may be applicable not only to consumer real estate but also to some categories of “specialty collateral” (antique guns, antique cars, etc.) for which the number of potential buyers may be limited, or for which a properly organized sale may require extra preparation.  If the bank will be foreclosing real estate, there is a possibility that interest will continue to accrue at a default rate for a somewhat extended period of time.  However, the effect of obtaining a judgment (a necessary step in the foreclosure process) is to determine and fix the amount owed on a note (including default interest, if applicable) and to convert that into a judgment.  Once judgment is rendered, further interest can only accrue at the statutory rate, not any default rate.

 The bottom line is this:  A bank should consider where it is going with a proposed “default rate” on consumer loans.  After identifying situations in which the rate is legal, the bank should try to understand in advance whether it will actually gain much by imposing a default rate in particular situations—either in extra interest earned, or as a deterrent that will help to assure prompt payment.  If so, the bank might consider it—but possible “customer relations” issues (reputational problems) should always be taken into account.