The Dodd-Frank Wall Street Reform and Consumer Protection Act is a massive piece of legislation passed by Congress in 2010 as part of comprehensive reform of financial regulation. Our focus is Title XIV, entitled “The Mortgage Reform and Anti-Predatory Lending Act,” which pertains to residential loans and lending practices. Title XIV will be referred to simply as “Dodd Frank” or the “Act.” The broad intent is to put an end to predatory lending practices, particularly the making of loans to those who cannot afford to pay them back. More lender disclosures and borrower protections are required.
Dodd-Frank achieves many of reforms by amendments to the Truth-in-Lending Act (“TILA”) and the Real Estate Settlement Procedures Act (“RESPA”). The new Consumer Financial Protection Bureau (“CFPB”), already an active and successful federal agency, is charged with issuing regulations to implement Dodd-Frank. Regulations and forms, as they are promulgated over the coming years, are likely to present as great a compliance challenge as provisions of the Act itself.
New federal and state laws have combined to forever alter the status of Texas as a haven for residential owner finance. “Owner finance” includes the traditional model (the seller gives a warranty deed to the buyer who then executes a note secured by a deed of trust); wraparounds (the buyer executes a wrap note and makes payments to the seller who then pays the underlying lender); and various forms of land trusts. Dodd-Frank applies to all of these.
Overlap with other Legislation
Dodd-Frank overlaps the federal SAFE Act, formally known as the “Secure and Fair Enforcement for Mortgage Licensing Act of 2008.” The SAFE Act is implemented as “T-SAFE” in Texas. The intent of the law is to achieve better consumer protection by regulating lending practices that were significantly abused in the past. A residential mortgage loan origination license or “RMLO” is required for professional investors. In other words, the seller must be an RMLO or there must be an intermediary involved in the transaction who has an RMLO license – except in sales of the seller’s homestead and sales to immediate family members.
If one wants the big picture of what has happened to the practice of owner finance in Texas over the last decade, then Dodd-Frank and the SAFE Act should be considered alongside the 2005 amendments to Chapter 5 of the Texas Property Code (Sec. 5.061 et seq.). These amendments include extensive regulations upon all forms of executory contracts, including contracts for deed and lease-options. Penalties on the seller for violations of the revised Property Code are severe.
Summary of Dodd-Frank
Title XIV Subchapter B, Sec. 1411 of Dodd-Frank requires that a seller/lender in a residential owner-financed transaction determine at the time credit is extended that the buyer/borrower has the ability to repay the loan. Specifically: “A creditor shall not make a loan that is a covered transaction unless the creditor makes a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms” (12 C.F.R § 1026.43(c)(1)). The lender is obligated to investigate eight specific factors relating to the borrower:
current income or assets;
current employment status;
monthly mortgage payment;
other monthly mortgage payments arising from the same purchase;
monthly payment for other-mortgage-related expenses (e.g., property taxes);
the borrower’s other debts, and
the borrower’s debt-to-income ratio (DTI).
This is a non-exclusive list, a minimum standard that lenders must follow. A prospective lender should also consider how much a borrower will have left over for life’s necessities at the end of the month, after all bills have been paid. All of this must be based on verified and documented information. This is referred to as the “ATR” (ability to repay) requirement.” Result? “No doc,” “low doc,” and other “liar loans” are, for now at least, effectively banned. So are teaser rate loans. If the mortgage is adjustable, the lender must consider the highest rate the borrower will have to pay in order to determine compliance with the ATR rule.
Additionally, an owner-financed note must have a fixed rate or, if adjustable, may adjust only after five or more years and be subject to reasonable annual and lifetime limitations on interest rate increases. Negative amortization loans (always risky) must be accompanied by disclosure and counseling for first-time buyers. And prepayment penalties are banned.
Regulations Issued by the CFPB
Complex laws such as Dodd-Frank are nearly always passed in bare-bones form. They are skeletal structures that require the appropriate administrative agency to issue rules and policies in order to implement the law. The CFPB derives its authority from section 1053 of the Dodd-Frank Act, 12 U.S.C. 5563(e), as well as its general rulemaking authority to promulgate rules necessary or appropriate to carry out federal consumer financial laws (12 U.S.C. 5512(b)(1)).
The CFPB has been aggressive about rulemaking and has taken significant liberties in its interpretation of both the statute and the intent of Congress. For example Subtitle B, Sec. 1411(a)(2) appears to frown on “nonstandard loans” such as balloon notes. The CFPB, however, has focused on the ATR rule as the heart of the owner financing part of the law, rather than deciding that any particular type of loan (balloons for example) should be prohibited. Note that certain types of loans – home equity lines of credit, timeshare plans, reverse mortgages, and temporary or bridge loans – are exempt from the ATR rule.
De Minimis Origination Exception to Dodd-Frank
CFPB reg. sections 1026.36(a)(4) and (5) provide a de minimis exception for individuals who do only one transaction in any twelve-month period; and for entities (such as LLCs) who do three or fewer owner-financed transactions in any twelve-month period. (Recall that, legally speaking, entities are also considered “persons.”). The exception is accomplished by stating that such “persons” are not included within the definition of “loan originators:”
4. SELLER FINANCERS; THREE PROPERTIES.
A person (as defined in § 1026.2(a)(22)) that meets all of the following criteria is not a loan originator under paragraph (a)(1) of this section:
The person provides seller financing for the sale of three or fewer properties in any 12-month period to purchasers of such properties, each of which is owned by the person and serves as security for the financing.
The person has not constructed, or acted as a contractor for the construction of, a residence on the property in the ordinary course of business of the person.
The person provides seller financing that meets the following requirements:
The financing is fully amortizing.
The financing is one that the person determines in good faith the consumer has a reasonable ability to repay.
The financing has a fixed rate or an adjustable rate that is adjustable after five or more years, subject to reasonable annual and lifetime limitations on interest rate increases. If the financing agreement has an adjustable rate, the rate is determined by the addition of a margin to an index rate and is subject to reasonable rate adjustment limitations. The index the adjustable rate is based on is a widely available index such as indices for U.S. Treasury securities or LIBOR.
The important item to note about this exemption is that the lender, exempted or not, must still comply with the ATR rule.
Since the foregoing exception applies only if the seller has not constructed a residence on the property in the ordinary course of business, professional builders who want to owner finance their new homes do not fall within the scope of the exception, no matter how many or how few homes they build.
Integrated Disclosures (the TRID Rule)
The CFPB is now the common regulator for Truth in Lending (TIL) and the Real Estate Settlement Procedures Act (RESPA), prescribing the form and content of the Loan Estimate and the Closing Disclosure, which in 2015 replaced the Good Faith Estimate and HUD-1 forms. The new forms are a significant advance in simplicity and, being written in plain English, are also easier to understand.
The Loan Estimate, which describes the proposed loan’s costs and terms, must be provided to the borrower within 3 days of receipt of the application. There is now a disclosure of the “estimated cash to close.” Also, itemization of all loan origination charges is required.
The Closing Disclosure (which combines the HUD-1 and final TIL statement) is 5 pages long and designed to track the format of the Loan Estimate in order to make side-by-side comparison easier. Separate Closing Disclosures must be given to buyer and seller. There are a couple of significant changes from past practice: the Closing Disclosure is now prepared by the lender (not the title company, as was the case with the HUD-1) and it must be received by the borrower at least 3 business days prior to closing, giving the borrower ample time to review what it says.
Investors who seller-finance 5 or fewer properties per year are exempt from the TRID rule.
Qualified Mortgages (“QMs”)
Accordingly, loans have been divided into two groups, with “qualified mortgages” (considered to be more stable loans) in the first group; and all others in the second group, which would include any loan with “risky” features. QMs (or at least those that are not “higher-priced”) are expressly designed to be a safe harbor from lender liability. ATR compliance (a landmine of liability in this context) is presumed.
What disqualifies a loan from being a QM? Examples would be interest-only provisions; negative amortization; higher than average interest rates; balloon payments; loan terms longer than thirty years; and loans with points and fees that exceed 3% of the loan amount. These riskier loans are not banned, but the ATR rule must be strictly applied. Any lender making such non-qualified mortgage should, as a liability-avoidance strategy, literally stuff its loan file with documentary evidence that the borrower can repay the debt as provided in the note. This file must be kept for a minimum of three years.
The CFPB website states “Qualified Mortgages generally require that your monthly debt, including the mortgage, isn’t more than 43% of your monthly pre-tax income. In some circumstances, certain small lenders may also decide that debt of more than 43% is appropriate.” Clear enough? Note that HUD and FHA loans are automatically considered to be QMs.
But it is not only stability and low risk that allow classification as a QM. Loans made in certain designated rural areas of the country qualify. The CFPB publishes a list of eligible counties on its website.
Lenders are similarly categorized, with “creditor” and “small creditor” being defined terms. “Creditors” are those who make 5 or more home loans per year, unless the loan in question is a high-cost mortgage loan (HPML), in which case the lender is a creditor regardless. “Small creditors” are those who make 500 loans or less per year and do not have more than two billion dollars in assets. Different rules apply.
Even persons knowledgeable in the lending industry can be forgiven for being confused about the rules around Dodd-Frank. It is suggested that, before deciding which rules apply in any given case, one should consult the CFPB website as follows:
Go to consumerfinance.gov
Click on “Law and Regulation”
Click on “Regulatory Implementation” on the drop-down menu
Click on “Title IV Rules”
Scroll down to a chart entitled “Rule/Compliance Guide”
Click on “Ability to Repay/Qualified Mortgage”
Investors and the Balloon Problem
Dodd-Frank, at least as interpreted and implemented by the CFPB, does not expressly ban balloon mortgages. The CFPB website states “You can still opt for a balloon-payment mortgage when the lender meets the requirements to be considered a ‘small creditor,’ and your mortgage meets other criteria.” For those concerned with the potential liability of making a risky loan and/or violating the ATR rule, this is rather vague; it creates a significant challenge for investors who typically include balloon provisions in their owner-financed notes.
Beginning January 10, 2016, balloon notes originated by small creditors will be classified as qualified mortgages only if the small creditor does business primarily in rural or “underserved” areas. All other balloon notes will be subject to the ATR rule.
Until the CFPB rules reach a higher level of clarity, investors should be wary of selling properties using balloon notes. Potential liability is described in the next section.
Owner-financing investors should not push the envelope on interest rates either, even if the proposed loan is otherwise a QM. Higher-priced loans only receive a rebuttable presumption that the loan is a QM – not an absolute certainty. And there are extensive pre-loan disclosures required. The borrower must also get a certification form a housing counselor that he or she has received counseling the high-cost mortgage being offered.
The CFPB offers two criteria for what constitutes a higher-priced loan: “a first-lien mortgage for which, at the time the interest rate on the loan was set, the APR was 1.5 percentage points or more over the Average Prime Offer Rate (APOR);” or “a subordinate-lien mortgage with an APR that, when the interest rate was set, exceeded the APOR by 3.5 percentage points or more.” So the days when an owner-financing seller could determine the note’s interest rate by reference solely to the state usury rate are behind us.
Dodd-Frank 2.0 – The Economic Growth, Regulatory Relief, and Consumer Protection Act
Signed into law in 2018, “Dodd Frank 2.0” contains six titles which modify Dodd-Frank. Generally, the Act is (unsurprisingly) mostly about reducing regulations on banks and mortgage lenders. Lenders under $10 billion in assets are now exempt from the Volcker Rule based on the theory that these institutions are too small to cause the entire system to fail. This is a dubious conclusion, especially considering that $10 billion is not really a “small” number, nor does this approach take into account the tendency of failing institutions to cascade.
Two titles, however, Title III and Title IV, actually expand consumer protections in the areas of credit reporting and student loans. Even so, it is difficult to see Dodd-Frank 2.0 as anything other than a gift to big banks.
An approaching tide of lawsuits?
Investors should anticipate that borrower suits against lenders based on the evolving CFPB rules (the ATR/QM rules specifically) will be a growth industry in the next decade, particularly since lenders are now prohibited from including mandatory arbitration clauses in their notes. Prudence dictates that one avoid being on the wrong side of that trend, so owner-financing of all types should be approached with caution.
Violation of the ATR/QM rules allow a consumer to sue for actual damages, statutory damages (including all finance charges and fees), attorney’s fees and court costs. The burden of proving that the ATR determination was reasonable and made in good faith falls upon the lender. Consider this: if the borrower defaults early in the loan, but not as a result of a serious financial or other setback, then this is considered possible evidence that the lender was unreasonable!
The statute of limitations is three years from the date of the violation by the creditor. A defense to foreclosure in the form of a set-off is also provided. After three years, the consumer can bring ATR claims only as set-off/recoupment claims in a defense to foreclosure.
There is also the possibility of enforcement by regulators. Even though the CFPB under Republican leadership has backed off its more aggressive rulemaking and enforcement actions, state attorneys general are more and more stepping into the gap.
Real estate investors are often viewed by jurors as untrustworthy predators. It is a safe bet that future juries will, on the whole, not hesitate to find investors who are also lenders “unreasonable” under Dodd-Frank and therefore liable for substantial verdicts.
The Act establishes a duty of care for mortgage originators (a broadly-defined category under Subtitle A Sec.1401) who are now required to be qualified and licensed. Who is a “mortgage originator?” Anyone who takes a residential mortgage loan application; anyone who offers or negotiates terms of the transaction; and/or anyone who assists a borrower in obtaining or applying for a residential mortgage loan. This definition obviously includes all mortgage brokers but would seem to be broad enough to include certain support personnel as well, even though persons who perform purely administrative or clerical tasks are expressly excluded. Real estate brokers are expressly excluded from the definition of a mortgage originator. However, real estate lawyers should take heed of the broadness of this definition and make sure their legal documents include a disclaimer to the effect that they have not participated in obtaining or negotiating terms of a client’s loan.
Mortgage originators are prohibited from steering borrowers to particular mortgage products in exchange for hidden fees, and this is backed up by a treble-damages penalty. Additionally, the previous practice by some refinance lenders of encouraging default on an existing loan before extending a new loan is banned. Mandatory arbitration provisions in loan documents (which always, in practice, favor the creditor) are prohibited.
Among regulations issued by the CFPB is the requirement that those who provide services in connection with residential real estate loans be subjected to scrutiny as to qualifications, character, and E&O coverage. Lenders are effecting this requirement by means of increased vetting of all participants in the loan process, including real estate lawyers who act as fee attorneys in the closing of transactions.
Borrower Defense to Foreclosure
Subchapter B Sec.1413 permits the borrower to assert a defense to foreclosure if the lender or mortgage originator violated the anti-steering or ability to repay provisions of the law. This is clearly designed to penalize the formerly widespread practice of putting under-qualified borrowers into loans that they could not afford to repay.
A Final Word about Dodd-Frank and Owner Finance
Dodd-Frank is an extremely complex law that is being subjected to substantial evolution by the rules that are intended to implement it. The text of the original statute is not difficult to find online. It can be a challenging read. The ensuing regulations (both existing and proposed), which are at least as convoluted as the statute, can be examined at the website of the CFPB (www.consumerfinance.gov/regulations). The reader should check current regulations before relying on any information provided by this article.
Owner finance, more regulated than ever before, can now be a precarious venture for a real estate investor who is acting as both seller and lender. Consult a real estate attorney who is specifically knowledgeable about Dodd-Frank before entering into a sales contract calling for owner finance, and never use seminar forms from non-lawyer “gurus” or forms off the internet to document such a transaction. These are likely to be non-Texas specific and inadequate under the many state and federal laws and regulations that now pertain to owner financing.
Information in this article is provided for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is retained and expressly retained in writing to do so.
Copyright © 2019 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.