Charles J. Jacobus

TEXAS REAL ESTATE LAW 11E

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Chapter 14

Interest and Finance Charge

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Interest and Finance Charge

• The mortgagor-mortgagee relationship is one of the last vestiges of true free enterprise.

• The lender makes an effort to maximize the return on investment, and the borrower shops around to find the best rates for the loan.

• Texas and the U.S. government has sought to protect borrowers from loan sharks and con artists in the lending business.

• Legislatures (both state and federal) have made a concerted effort to effect disclosure of loan costs (finance charges) and to limit the amount of interest that can be charged.

• There are few areas of lending that have been more litigated, or that more directly affect the consumer, than interest and finance charge.

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Regulation Z - Introduction

• Originally passed in 1968, the Truth-in-Lending Act (T-i-L Act), required extensive disclosure by creditors when making loans to consumers.

• The T-i-L Act placed the job of implementing the act on the Board of Governors of the Federal Reserve System.

• This was accomplished by the Federal Reserve Board’s promulgation of Regulation Z (Reg. Z).

• The purpose of the T-i-L Act is to ensure that everyone being extended commercial credit by a creditor covered by the act is given meaningful disclosures with respect to the cost of the credit being extended.

• The disclosures must be clear and according to the statutory forms published pursuant to the T-i-L Act and Reg. Z.

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Regulation Z - Application

1. The credit is offered or extended to consumers (natural persons).

2. The credit is offered and extended regularly (more than five times for transactions secured by dwellings in a preceding year).

3. The credit is subject to “finance charge” or payable by written agreement in more than four installments.

4. The credit is extended primarily for personal, family, or household purposes.

Creditors covered by the T-i-L Act must comply fully with all Reg. Z requirements if four conditions are met:

When does Reg Z apply?

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Regulation Z – Finance Charge and Annual Percentage Rate

The disclosures must be made in terms of deferred finance charge and annual percentage rate (APR), so that the consumer will clearly

understand what is being disclosed to him.

APR

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Regulation Z – Finance Charge

. . . the sum of all charges, payable directly or indirectly by the creditor as an incident to or as a condition of the extension of credit, whether paid or payable by the customer, the seller, or any other person on behalf of the customer to the creditor or a third party . . . [Reg. Z, Section 226.4(a)].

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Regulation Z – Annual Percentage Rate (APR)

. . . the rate charged (expressed as a percentage) as determined by applying the federal government’s definition of finance charge to the

federal government’s definition of consumer credit . . .

Finance ChargeThe sum of all charges,

payable directly or indirectly by the creditor as

an incident to or as a condition of the extension of credit, whether paid or payable by the customer,

the seller, or any other person on behalf of the

customer to the creditor or a third party.

Consumer CreditCredit offered or extended to consumers (natural persons),

regularly (more than five times for transactions

secured by dwellings in a preceding year), subject to

“finance charge” or payable by written agreement in more

than four installments, and extended primarily for

personal, family, or household purposes.

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Regulation Z – Creditor and Arranger of Credit

Arranger of Credit

Could include real estate

brokers who arrange for

sellers to take second lien

loans.

Creditor

A person who extends credit more than five

times for a transaction

secured by a dwelling in a

preceding calendar year or in a current calendar year

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Regulation Z

• There are exclusions from the determination of finance charges as they apply to certain real estate transactions (primarily in buying homes).

• Good practice favors disclosure of the items, to ensure compliance.

• There is no ceiling to finance charges; the requirements only specify that the charges be disclosed.

• T-i-L and Reg Z have both been changed numerous times.

• A violation of T-i-L creates an unavoidable liability.

• Must be strictly complied with, and verbal disclosures are not effective.

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Regulation Z - Right of Rescission

• Applies to all consumer loans, although mortgages for acquisition of residential real estate (or initial construction) are exempt.

• A consumer may rescind the transaction by midnight of the third business day after:

(1) she has signed the documents to secure the credit; or (2) delivery of the notice of right to rescind; or (3) delivery of all material disclosures.

• If the consumer exercises this right, the documents are void, and any money advanced by the consumer (other than for the lender’s actual expenses) must be returned to the consumer.

• The consumer can waive this right to rescind for a bona fide financial emergency.

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High Cost Mortgages

• In an attempt to regulate predatory lending, Congress enacted the Home Owners Equity Protection Act of 1994 (HOEPA).

• High Cost Mortgages are defined as “a consumer credit transaction,” secured by consumer’s principal dwelling, and in which either:

(1) the annual percentage rate at consummation will exceed by more than eight (8) percentage points, 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 creditors; or (2) the total points and fees payable by the consumer at or before loan closing will exceed the greater of eight percent (8%) of the total loan amount, or $480.00 (this figure is subject to adjustment by Congress).

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High Cost Mortgages

• HOEPA regulations do not apply to “Residential Mortgage Transactions,” which are defined as “loans used to finance the purchase or initial construction of the borrower’s principal dwelling.”

• Creditors cannot include balloon payments of less than 5 years, negative amortization, increased interest after default and certain calculations of payment rebates and penalties.

• Creditors cannot extend credit if the consumer will be unable to make the scheduled payments to repay the obligation.

• High cost home improvement loans cannot be funded directly to the Contractor, but must be paid jointly to the Contractor and owner or to a third party escrow agent through an escrow agreement.

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Interest

• In contrast to the federal government’s determination of finance charge is the Texas definition of interest.

• Interest is “the compensation allowed by law for the use of money

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Usury

• Usury is charging an interest rate in excess of that allowed by law.

• It has three essential elements: (1) a loan of money. (2) an absolute obligation that the principal be repaid. (3) the exaction of a greater compensation than allowed for by law.

• The “charging” of interest is liberally construed.

• It can include any charge unilaterally placed on an account as interest and can even include a payoff quote.

• The Texas statute may not apply, however.

• Texas courts have upheld the theory that parties can agree in their contract to enforce the usury law in any state applicable to their transaction so long as there is significant contact with that state.

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Usury

Except as otherwise fixed by law, the maximum rate of interest in Texas is 10% per year.

Of course, there are many other interest rates “otherwise fixed by law.”

When the original principal is $250,000+ the max rate is 18% per year.

There are also optional interest ceilings.

They do not apply to a loan secured by the borrower’s homestead.

The ceilings can be calculated weekly, monthly, quarterly, or annualized.

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Usury

• The weekly ceiling is computed by: (1) multiplying the auction rate by 2. (2) rounding a result obtained to the nearest 1/4 of 1%.

• The “auction rate” means the auction average rate quoted for 26-week treasury bills issued by the U.S. government.

• The monthly ceiling is computed by averaging all of the weekly ceilings, computed using rates from auctions held during the calendar month preceding the computation date of the monthly ceiling.

• The minimum ceiling is 18% per year and the maximum ceiling is 24% per year.

• The quarterly ceiling or annualized ceiling is computed by averaging all of the weekly ceilings using average rates for auctions held during the three calendar months preceding the computation date of the ceiling.

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There are other provisions that allow for other rates of interest in special situations such as consumer credit transactions, FHA and VA loans.

However, for most loans secured by real estate that are not consumer credit transactions, or controlled by federal statute, the above interest statutes are controlling.

Usury

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Federal Intervention of State Usury Laws

Federal laws were passed that declared that the constitutional laws of any state expressly limiting the rate or amount of interest shall not apply to any loan that is:

1. Secured by a first lien on residential property, by a first lien on stock in residential cooperative housing corporations, or by a first lien on a residential manufactured home.2. Made after March 31, 1980.3. Described in Section 527(b) of the National Housing Act, 12 U.S.C.1735f-5(b) (federally related mortgage loans).

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Federal Intervention of State Usury Laws

Another provision of the federal statute that is applicable to business or agricultural loans provides a new ceiling for loans made for business or agricultural purposes in the amount of $1,000 or more.

These loans may charge a rate of interest of not more than 5% per annum in excess of the discount rate.

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Determination of Interest

• What constitutes interest as a charge for the “forbearance or detention” of money?

• There are an almost indeterminable number of fees that have been tacked on to all kinds of loan transactions.

• Most of these loan charges are clearly established and understood.

• The lender must be very careful in requiring these charges, so as not be considered usurious.

• Some of the more common charges for obtaining a loan may constitute interest and deserve more detailed discussion.

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Late Charges

• Earlier cases in Texas tended to indicate that late charges could be usurious in certain circumstances.

• A controlling issue seems to be whether or not the late fee is charged for a service performed or for a detention of money past the due date.

• Secondly, if it is a charge for the detention of money past the due date, the controlling concern is how to calculate the interest rate.

• Recent Texas legislation has eliminated this conflict.

• The federal law (late charges are interest but covered by the federal preemption) controls.

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Points, Commitment Fees, and Loan Brokerage Fees

• Points, commitment fees, and loan brokerage fees are fees paid to a lender or loan broker when obtaining a loan.

• The value of these fees is normally measured in points, each point being 1% of the loan value.

• Although often used interchangeably, points, commitment fees, and loan brokerage fees are for separate and distinct purposes.

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• For the purposes of this discussion, will be a fee charged for entering into a loan contract charged by, and paid to, the lending institution.

• Generally, whether or not points are construed to be interest is determined by what the points are to be used for.

• If the points are not directly attributable to expenses incurred by the lender in making such loan, the points will constitute interest.

• However, if the points are charged for a definite expense, they will not constitute interest.

Points

1% 2% 3% 4% 5%

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Commitment Fees

• A commitment fee is normally a fee charged for the promise of securing funds at some future date.

• This does not fall within the definition of interest.

• A commitment fee can be characterized as an option to enter into a future loan, and as long as the fee was reasonably related to the risks taken by the lender, it will not be construed to be interest.

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Loan Brokerage Fees

• Fees charged by mortgage brokers for placing the loan with a lender.

• Not normally considered interest if the fee does not go to the lender itself.

• It is common for a mortgage company or savings and loan to operate as a mortgage broker and to charge points as a fee for finding another lender to make the loan.

• In this capacity, the institution is serving only as a mortgage broker.

• In such case, the fee is not used as a cost for obtaining the loan but instead is a fee for paying the broker for finding a lender.

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Prepayment Penalties

• Prepayment penalties (also measured in points) are the fees that a lender charges the borrower for paying off a loan prematurely.

• When a borrower has entered into a contract to pay 9% interest over a period of 30 years, he has normally contracted to pay a certain amount of interest over that 30-year period.

• Thus, if the contract is terminated prematurely (by prepayment), there is a certain amount of interest that will not be paid.

• Therefore, the lender charges a certain number of points as a prepayment penalty.

• This charge would appear to be within the legitimate expectation of damages on the lender’s part.

• New Texas legislation now makes it clear that prepayment charges are not interest.

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Partial Release Fees

• When a borrower requests that the lender release a portion of the real estate, the lender would charge a premium for the portion to be released, but also a partial release fee.

• This fee is normally attributable to the preparation of instruments, bookkeeping, and clerical costs for releasing the security and for the resulting adjustment of the principal balance due under the terms of the loan.

• Partial release fees of this type are not considered to be interest.

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Compensating Balances

• It is a common practice for a lender to require the borrower to make deposits or purchase certificates of deposit to be pledged to the lender.

• These arrangements are often verbal transactions and are not made part of the loan documents themselves.

• The compensating balances generally create a separate obligation (on which interest is paid by the lender) and are not deemed interest.

• If the lender freezes the loan proceeds or requires the compensating balance in the loan document, it may be considered interest.

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Matured Interest

• Most promissory notes have penalty provisions in the event of default.

• Usually the entire principal amount is matured and matured unpaid principal and interest will bear interest at 10% per annum.

• This is sometimes referred to as interest on interest.

• This penalty provision does not constitute interest.

• In a very old Texas case (1896), the Texas Supreme Court held that such a provision represents a new obligation once the default has taken place, and the interest on the note and the interest on the past due principal payments do not constitute a new, higher rate of interest.

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Compulsory Loan Retirement

• Means the borrower pays off all of his preexisting indebtedness before obtaining a new loan.

• This normally is not considered interest.

• However, such a requirement may be considered interest if there is a required prepayment penalty on the loan to be paid off.

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Turnaround Sales

• In the case of Commerce Savings Association v. GGE Management, there was a requirement that the borrower sell a project to the lender for $349,000.

• The lender resold the property to the borrower for $400,000.

• The extra costs charged in this transaction were determined by the jury to be interest and the transaction disguised to evade the usury statute.

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Equity Participation

• Lenders may participate in the equity of a project without additional cost to themselves as lenders.

• The key determination when a lender is involved in equity participation is whether or not the lender is taking a risk similar to the borrower.

• If the lender gets a preferred return on his investment, this may be determined to be interest, and possibly usurious.

• If the lender shares in the risks, and the return on his investment is not readily ascertainable, he is considered to be a true equity participant.

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Required Incorporation

• Law allows businesses to pay higher interest than noncorporate borrowers.

• Lenders sometimes simply require that the borrower incorporate.

• The mere fact that a corporation was formed to obtain a loan does not render the transaction void, unless the corporation was an obvious sham that had no corporate purpose.

www.sos.texas.gov

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Seller’s Points

• A Texas case (which was settled prior to the actual trial) considered an interesting point as to whether or not seller’s points constituted interest under Texas law.

• In the judge’s opinion seller’s points should be construed to be interest under Texas law since the seller raised the sales price of his property to cover the cost of the points charged by the lender.

• This is not a precedent setting decision but is considered by most to be well reasoned under Texas law.

• Many lenders now require sellers to sign affidavits at closing indicating that the seller did not raise his price to cover the cost of the points.

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Spreading

• Once it has been determined that points, turnaround sales, and other additional payments are interest there is a question as to how that interest is to be calculated to determine whether or not it is usurious.

• Texas has adopted the concept of “spreading”.

• The points for fees and commitments and other charges attributable to the loan transaction itself (although they are one-time charges) can be “spread” over the life of the loan to determine whether or not it would constitute usury over the entire period.

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Penalties for Usury

• Three times the interest, time price differential, or other charges that exceed the amount of interest allowed by law, and reasonable attorney’s fees.

• In no event shall the amount forfeited be less than $2,000 or 20% of the principal, whichever is smaller.

• There shall be no penalty for any usurious interest that results from accidental or bona fide error by the lender.

• Any person who contracts for or receives interest in excess of double the amount of interest allowed by the law shall forfeit all principal as well as interest and all other charges.

TREBLE THE INTEREST!

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Penalties for Usury

• A creditor is not liable to usury if, no later than the 60th day after the date the creditor actually discovered the violation, the creditor corrects the violation by taking any necessary action and making a necessary adjustment (including the payment of interest on a refund), and the creditor gives written notice to the borrower of the violation before the borrower gives notice of the violation or files alleging the violation.

• If there is a “savings clause” (a clause that states the lender does not intend to charge usurious interest or provides for a rebate of any excess interest to the borrower, or both), a lender may not be liable for the statutory penalties for usury.

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CASE STUDY FOR DISCUSSION

1. McGee borrowed money from Friendly Lender Savings and Loan Association to build two homes. She borrowed $38,400 at 9% per annum. Upon closing, she noticed there was a charge on the closing statement for a “commitment fee” of $768, or 2% of the principal. McGee alleges that it was interest under Texas law. The savings and loan contends that it is, in fact, a “commitment fee” and is not interest. What legal ramifications do you foresee?

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Questions for Discussion

1. When does the Truth in Lending Act and its related Regulation Z apply to a credit transaction?

2. Under Truth in Lending what is the “finance charge” and how is it calculated?

3. What is the right of rescission under the Truth in Lending Act on mortgages for acquisition of residential real estate?

4. What other charges related to obtaining a loan might be considered interest and which others are not?

5. Explain the concept of spreading.