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Home Equity Loan Improvements
There's more Regulation Z compliance on the way, courtesy of the Home Equity Loan Consumer Protection Act. This fall banks will have to implement the new home equity loan disclosure rules the Federal Reserve Board was required to issue under the act.
The Federal Reserve released the final version of the home equity regulation on June 5. The rules were made effective June 7. However, compliance is optional until Nov. 7 because Congress gave institutions five months after finalization to start. However, there's no time like the present.
This column is devoted to bankers' most common questions about the demands of this complicated rule. You should, of course, check the regulation and consult legal counsel before acting on these suggestions.
Q. This is a disclosure regulation. Does that mean that, while we must provide customers lots of information about home equity products, we are free to design them as we see fit?
A. No. The regulation leaves many design matters to lenders and provides options in a number of other areas. At the same time, however, it creates three absolute restrictions on design:
(1) If you offer a variable-rate program, you must use a base rate beyond your control. Information on that rate must be generally available to the public. Examples include the prime rate as published in The Wall Street Journal or rates on U.S. government securities.
(2) Lenders generally may not terminate the plan and accelerate the balance before the loan's scheduled expiration. There are three exceptions: customer fraud or misrepresentation; failure to meet repayment terms; or action or inaction adversely affecting collateral.
(3) Lenders may not unilaterally change any but insignificant terms of a home equity plan, with the following exceptions:
* You may make changes provided for in the contract, as long as both the triggering event and the resulting changes are stated specifically in the contract.
* You may substitute a new index if the original index becomes unavailable. This is subject to two conditions: the new one's historical fluctuations must be substantially similar to the old one and it must produce a rate similar to that in effect when the old index became unavailable.
* You may prohibit further advances or reduce the credit limit in four circumstances: if the value of the dwelling falls significantly below original appraised value; if you have a reasonable belief, based on evidence, that there has been a material adverse change in the customer's ability to repay; if the customer defaults on any material obligation he's agreed to under the plan; or if government action--such as a reduced usury ceiling--either precludes imposition of the agreed upon annual percentage rate (APR) or adversely affects the priority of your bank's security interest.
If you impose restrictions based on these four situations, you must reverse your action if and when the problem is eliminated. Preparing Early Disclosures
Q. What are the basic early disclosure requirements?
A. The heart of this regulation is a new requirement that customers be given detailed disclosures and a general brochure about home equity plans when provided with an application form. The only exceptions are for applications contained in magazines or taken by telephone or through third parties. In these cases, the lender can mail or deliver the disclosures and brochure to the customer within three business days after receiving the application.
Q. Do these disclosures have to be in a form the customer can keep?
A. Not when they are provided with the application. This means that you have the option to simply print the disclosures on the application form. If you do so, however, you must include a statement suggesting that the customer make a copy.
Q. Must early disclosures be presented in any particular format
A. Yes. You must be sure that certain required terms are grouped together and are segregated from other information. These terms include the following (assuming they are applicable); the first four must precede all others:
* The customer should keep a copy of the disclosure.
* Any time limit within which the customer must apply to receive the terms described. Alternatively, include a statement that terms may change. In addition, the lender must state that the customer has the right to a refund of any fees if any terms change and if, as a result, the customer decides not to enter into the plan.
* A warning that the lender is acquiring a security interest in the customer's dwelling and that the customer could lose his home if he defaults.
* An advisory that, under certain circumstances, the lender may terminate the plan and accelerate any outstanding balance; prohibit further advances; reduce the credit limit; or otherwise change the plan, as provided in the loan agreement.
* A discussion of the plan's payment terms. This should include: the length of the draw period and any repayment period; an explanation of how the minimum payment is determined, the timing of payments, and whether making only minimum payments would not repay any or all of the principal balance; and the fact that the plan permits conversion of the balance to a fixed-term loan.
You must also include an example, based on a $10,000 outstanding balance and a recent APR, showing the minimum periodic payment, balloon payment, and the time needed to repay the $10,000 loan making only the minimum and balloon payments, with no additional advances.
* For fixed-rate loans, the APR must be one that was in effect within the previous 12 months. For variable-rate plans, the historical table satisfies this requirement.
* A description and itemization of loan fees that the lender charges to open, use, or maintain the account. These can be stated as dollar amounts or percentages. You must also give a total dollar estimate of fees imposed by third parties and invite the customer to request more specific information.
* The fact that negative amortization may occur and that it increases the principal balance and reduces the customer's equity.
* Any limits on the number and size of credit extensions within any time period and any minimum balance or draw rules, stated as a dollar amount.
* A statement that the customer should consult a tax advisor regarding the deductibility of interest and charges.
Q. If we offer a variety of home equity plans, are we required to have a separate disclosure notice for each one?
A. No. The bank can choose to devise a separate plan disclosure for each home equity product or to use a more generic disclosure to cover all of them.
If you use individual disclosures, you must inform customers that they should inquire about other options.
If you use a single generic disclosure, you are required to spell out any linkages or relationships affecting the availability of certain terms. For instance, if you tell the customer that your home equity loans are available with certain payment plans, and if the customer's opportunity to select these payment plans varies based on other loan terms, these restrictions would have to be explained.
An example of such linkages: Say a bank offers two plans, one with a five-year term and the other with a ten-year term. The bank permits interest-only payments under the five-year plan, but requires payments of interest and principal under the ten-year plan. A generic disclosure would have to point out such a difference.
Q. Where do we get the brochure that must be given out?
A. You can either use the model brochure provided by the Federal Reserve Board or develop your own that is "substantially similar." If you want to use the Fed's version, you can obtain a limited number of original copies from your Federal Reserve Bank and reprint them verbatim. You could also reprint the Fed brochure with the bank's name and logo.
Q. The disclosures that go onto application forms seem fairly straightforward. But I foresee difficulties sending the required notices out within three days for telephone, third-party, and magazine insert applications. Is this going to be a management problem area?
A. Undoubtedly. You need to have a system and training for handling these applications. Staff should be directed to note them on a special log identifying the applicant, the time of receipt, and the source of the application. You then need to generate the required disclosures and record the date they were sent.
Q. We must disclose the circumstances under which we can change the terms of the plan and what the changes may be. These could grow quite lengthy. Must they all be included in the early disclosures?
A. No. You can include them all if you want to; if you do, you need not group them with the other early disclosures. However, if you prefer, you can simply disclose that the borrower may obtain a list of the conditions under which the lender could take these actions.
In either case, the segregated disclosures must state that the lender has the right to terminate, accelerate, prohibit new advances, reduce the credit line, or make other changes. You must also state the fees for termination.
Management tip: Designate which employees have the authority to terminate or change the plan terms. Then make sure these employees understand the rules. Permitting decentralized decision-making could lead to legal and customer relations problems.
Q. Our bank's home equity lines can be accessed with a credit card. Do we have to incorporate the new credit card early disclosures (ABA BJ, June, p. 14) into those for our home equity plan?
A. No. The Federal Reserve's new credit card rules specifically excluded such plans.
Q. What is the difference between "early" disclosures and "initial" disclosures?
A. The early disclosures are the ones added by this regulation--those that must be provided with the application. The initial disclosures are the main Truth-in-Lending disclosures that have always been required at or before loan consummation.
Q. Does the new rule affect the initial disclosures we must make?
A. Yes. You must include in the initial disclosures the early disclosure terms that do not duplicate already-required initial terms. In addition, the initial disclosures must include the full list of the conditions under which the bank can terminate or modify the plan, incorporating, of course, the restrictions described earlier. It is not sufficient here to simply tell the customer that he may obtain such a list, in contrast to the early disclosure requirements.
Q. Does the regulation require changing our standard loan agreements?
A. Very likely. As explained earlier, you must assure that the agreement uses a publicly available index beyond your control; that it only permits early termination within the circumstances permitted by the regulation; and that any provision for changing terms spells out specifically both the triggering event and the resulting change. An example of the latter: For an employee preferred-rate plan, the contract must provide that a specified higher rate will apply if the borrower's employment by the lender ends.
Q. Does the regulation change our ability to advertise these loans?
A. Yes. The rule adds new "triggering terms" to the advertising provisions of Regulation Z. "Triggering terms" are terms you cannot use in an advertisement without having to disclose additional information. For home equity loans, the new triggering terms are all of the terms required in the initial disclosures (except the security interest), as well as any payment terms. You may not make either positive or negative statements (such as "no annual fee") about these items without including, in the same ad, a clear and conspicuous statement of the following:
* Any loan fee that is computed as a percentage of the credit limit and an estimate of other fees for opening the plan, stated as a single amount or range.
* Any periodic rate used to compute the finance charge, expressed as an APR.
* The maximum APR, if it is a variable-rate plan. Q. There have been problems in the past relating to advertising the tax benefits of home equity loans. Are these addressed?
A. Yes. If you advertise that interest may be tax-deductible, you must assure that the ad is not misleading. The Fed suggests, for instance, that you also add that the customer should consult a tax advisor to determine the impact in his or her own circumstances.
Q. Are there any other advertising rules?
A. Yes. If your advertisement mentions a discounted initial rate, you must state how long that rate will be in effect and display a "reasonably current" undiscounted APR with equal prominence. If you advertise a minimum payment, you must also disclose that a balloon payment will result from it, if that is the case. Finally, you cannot refer to a home equity plan as "free money" or use any other misleading terms. Other Issues
Q. We are required to refund fees to customers who back out of an application because terms change. What is involved in handling this?
A. You must refund all fees, including credit report and appraisal charges, if the customer decides not to take the loan because terms changed between application and consummation. The only exception is if the APR has changed in accordance with a properly disclosed variable-rate feature.
Q. Third parties, such as loan brokers, distribute some of our application forms. Are they affected?
A. Third parties are obligated to provide the home equity brochure and, if they have them, the lender's early disclosures. However, the lender is not obligated to supply them with either. Nevertheless, it is probably a good idea to furnish at least the brochure.
Q. Once we have put the compliance machinery for this regulation into place, what problems may we encounter in staying in compliance?
A. For variable-rate plans, one problem will be the need to update your historical $10,000 example every year. This needs to show how the indexed rate would have moved every year for the previous 15 years (not beginning in 1977, as is required for closed-end adjustable rate mortgages). The historical example must be updated each year. A second maintenance problem will, of course, be the need to revise all your disclosures whenever program terms are changed for new accounts or when you offer new programs. When this happens, you need to review all steps taken to put together the initial compliance plan.
Marc Sylvester is expect based in Edison, NJ . He holds expertise in the banking and finance sector and is a consultant to leading business houses.
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