Co-Author: Julie A. Jacobs, Psy.D., J.D.
Part II: Owner Carry Financing and Prepayment Penalties under the Dodd-Frank Act
The Consumer Financial Protection Bureau (CFPB) promulgated a far-reaching new regulation in January, 2013, which will become part of the current Regulation Z. A portion of the regulation implements section 1414 of the Dodd-Frank Act which limits prepayment penalties in certain consumer credit transactions. This article will discuss the prohibitions and limitations on prepayment penalties outlined in the regulation and the applicability of this regulation to owner carry financing.
Limits on Prepayment Penalties under Regulation Z
When the new rules become effective on January 10, 2014, they will significantly limit the ability of creditors to include prepayment penalties in transactions covered by the regulation. Prepayment penalties will only be allowed in specific circumstances: the transaction must have an annual percentage rate that cannot increase after consummation of the transaction; it must be a qualified mortgage meeting requirements outlined below, and it cannot be a higher-priced mortgage loan (defined as a mortgage with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction by more than 1.5 percentage points for loans secured by a first lien or by 3.5 or more percentage points for a loan secured by a subordinate lien). Under the regulation, a “qualified mortgage” has the following characteristics: regular periodic payments that are substantially equal except for changes in interest rate on adjustable rate mortgages; a loan term of 30 years or less; the creditor considers income and debt of consumer; and the loan is eligible to be purchased or guaranteed by FNMA, FHLMC, HUD, VA, or RHS.
If a transaction meets the above requirements and a prepayment penalty is permitted, it must meet several conditions. First, prepayment penalties can only apply for the first three years after consummation of a loan; after three years, there can be no penalty for early payment. A penalty applied in the first 2 years following consummation of the loan is limited to 2% of the amount of the outstanding loan balance; one applied in the third year cannot exceed 1% of the outstanding loan balance. In addition to the above limitations, if a creditor offers a consumer a transaction which includes a prepayment penalty that meets the above conditions, the creditor is required to offer an alternative transaction that does not include such a penalty. By implementing these limits on prepayment penalties, the CFPB is seeking to protect consumers from so-called “predatory lenders” while also ensuring that affordable mortgage credit remains available to consumers.
Impact on Owner Carry Financing
The limitations described above apply to creditors who are extending consumer credit secured by a dwelling, and the definition of “creditor” is key to understanding the application of this regulation. For mortgage transactions, a “creditor” is defined in the regulation as a person who extends credit secured by a dwelling more than five times in a calendar year. Under this definition, the vast majority of people engaging in owner carry financing will not fall under the scope of these rules. As long as you extend such credit 5 or fewer times per year, the prepayment limitations will not apply to your owner carry financing. However, if you do make six or more loans in a year, these limitations will apply to your transactions, and assessment of a prepayment penalty in excess of the limits described above would be considered a violation of the regulation. If such a violation occurs, the remedy for the consumer would be a legal claim for damages, which would include the amount of the penalty plus reasonable attorney’s fees. Does the Rule Apply Retroactively?
As noted above, the revisions to Regulation Z regarding prepayment penalties will become effective on January 10, 2014. There are several other rules related to Dodd-Frank that have also been promulgated in recent months, and the effective dates of these regulations vary. However, none of the new rules will apply retroactively, so transactions that have already been consummated are not required to comply with the new rules regarding prepayment penalties. According to the CFPB, even the very earliest provisions of the new regulations will only impact transactions that are entered into on or after June 1, 2013. Thus, the new regulations will have minimal impact on transactions that have already occurred; however, if you are planning to extend owner carry financing after June 1 of this year, it will be important to seek guidance from your attorney to determine if any new regulations, such as the requirement to determine ability-to-pay, will apply to your transaction.
This article addresses prepayment penalties under Dodd-Frank. Part I addresses questions regarding owner carry financing under the SAFE Act.