Bridge Loans on Owner-Occupied Real Property
Note: This post is intended as educational material, not legal advice. Consult a lawyer before implementing any of the information in this post.
There is a lot of confusion in our industry concerning the application of consumer protection laws to residential bridge loans. In particular brokers need to know if the high-cost lending rules apply including Regulation Z’s Ability to Repay Rule and its 3 Day Right to Cancel Rule.
As seen in the discussion below, Regulation Z gives special treatment to “bridge or other temporary loans.” But the regulation does not define what a bridge or other temporary loan is except by reference to two scenarios: (A) a loan to enable a consumer to buy a new home before he or she has sold their existing one and (B) a ground-up construction loan. Here is an example of that discussion in the Official Staff Commentary to the Ability to Repay Rule (1026.43):
Under § 1026.43(a)(3)(ii), a temporary or “bridge” loan with a term of 12 months or less is exempt from § 1026.43(c) through (f). Examples of such a loan are a loan to finance the purchase of a new dwelling where the consumer plans to sell a current dwelling within 12 months and a loan to finance the initial construction of a dwelling.
I frequently have brokers ask me if other situations fit within the definition of a “temporary loan.” For instance, a person intends to sell their home but needs money to fix it up or cure a foreclosure. If this is what the regulation meant by a “temporary” loan then nearly every necessitous borrower would be exempt from a host of consumer protection laws. The only reliable applications of the term “bridge or other temporary loan” are the two cited above: (A) a loan to finance a new home while the borrower sells the old home and (B) a ground-up construction loan.
Confining our inquiry to the first scenario—a true bridge loan, there are variations in the application of Regulation Z based upon which property is being encumbered. So I have selected the three possible bridge loan scenarios and I will explain how Regulation Z treats each situation. What is common to all of the scenarios below is that a homeowner has selected a specific new home for purchase with the stated intention of selling their existing home. In addition the consumer states their intention to move into the new house within the following year. The assumption is made that the APR will exceed 6.5% over the Average Prime Rate Offer and is therefore both Higher-Priced (Section 35) and High-Cost (Section 32). The “High-Cost” designation is hard to avoid since points and interest are combined for APR purposes and compressed into a short period of one year.
Three bridge loan scenarios are possible: (1) the creditor liens only the existing home, (2) it liens on both the old and new home, or (3) it liens the new home only. As we will see below, the Ability to Repay Rule is inapplicable in all three scenarios as well as the Section 35 (Higher-Priced) loan rule. However, most bridge loans privately funded will fall within Section 32 high-cost limits and we will see that the law is less charitable to high-cost loans.
In bridge loans it is important to document the intention to make the new home the consumer’s new home within 12 months as well as the intent to sell the consumer existing home.
Scenario 1: Lender Takes a Deed of Trust on Existing Home Only.
The Ability to Repay Rule (1026.43(c)) Does Not Apply to Any Under 12 Month Bridge Loans:
Here is the Exemption in the Ability to Repay Rule:
1026.43 (a) Scope. This section applies to any consumer credit transaction that is secured by a dwelling, as defined in § 1026.2(a)(19), including any real property attached to a dwelling, other than:
(ii) A temporary or “bridge” loan with a term of 12 months or less, such as a loan to finance the purchase of a new dwelling where the consumer plans to sell a current dwelling within 12 months or a loan to finance the initial construction of a dwelling;
Conclusion: The Ability to Repay Rule does not apply to any true bridge loan secured by the borrower’s existing home only, future home or both. That is true regardless of whether the loan is priced to fall within the ambits of Section 35 or Section 32. This makes bridge loans a good source of safe revenue for a mortgage broker. Ability to Repay is subjective; the rest of the lending requirements are mechanical and black and white. Because the subjective element is eliminated, the broker’s risk is significantly reduced.
Section 35 (1026.35) (Higher-Priced Mortgage) and Section 32 (1026.32) Owner-Occupied Rules Apply Because the Law Regards the Borrower’s Existing Home as the Borrower’s “Principal Dwelling” for all Purposes.
Now let’s look at the high-cost rules, Sections 35 and 32. Remember those rules only apply to loans secured by the consumer’s principal dwelling so it is important to determine if the old house or the new house or both are considered the consumer’s principal dwelling. The Regulation helps us on this point:
1026.(a) Definitions. For purposes of this section:
(1) “Higher-priced mortgage loan” means a closed-end consumer credit transaction secured by the consumer’s principal dwelling with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction as of the date the interest rate is set
Commentary to 1026.23(a)(1)(3) Principal Dwelling.
When a consumer buys or builds a new dwelling that will become the consumer’s principal dwelling within one year or upon completion of construction, the new dwelling is considered the principal dwelling if it secures the acquisition or construction loan.
Because in Scenario 1 our loan is secured only by the existing home the above rule does not apply and the existing home is considered the principal dwelling. Section 32 would apply without the Ability to Repay Rule.
Lastly, what about the 3 Day Right to Cancel? We are, after all, placing a lien on the borrower’s current home. Regulation Z affords some protection here and preserves the Right to Cancel:
The 3 Day Right to Cancel (1026.23) is Preserved for an Under 12 Month Bridge Loan Secured by the Consumer’s Existing Home.
Commentary to 1026.23(a)(1)(4) Special Rule for Principal Dwelling
Special rule for principal dwelling. Notwithstanding the general rule that consumers may have only one principal dwelling, when the consumer is acquiring or constructing a new principal dwelling, any loan subject to Regulation Z and secured by the equity in the consumer’s current principal dwelling (for example, a bridge loan) is subject to the right of rescission regardless of the purpose of that loan. For example, if a consumer whose principal dwelling is currently A builds B, to be occupied by the consumer upon completion of construction, a construction loan to finance B and secured by A is subject to the right of rescission. A loan secured by both A and B is, likewise, rescindable.
Thus the 3 Day Right to Cancel Rule applies to a true bridge loan secured solely by the borrower’s current home.
Scenario 2: Lender Takes a Deed of Trust on Existing Home As Well As New Home.
In Scenario 2 we will assume the creditor takes a deed of trust on both the old home and the new home being acquired. As I noted above, the Ability to Repay Rule does not apply to any bridge loan, regardless of how it is secured.
Section 35 (1026.35) (Higher-Priced Mortgage) Owner-Occupied Rules Do Not Apply to a True Bridge Loan Secured by the Consumer’s Old and New Home
There is an exemption for all “bridge loans” in the Higher-Priced (Section 35) mortgage rules regardless of how they are secured. Section 35 has two aspects, an appraisal rule and an impound rule. Both exempt all bridge loans:
(2) Exemptions. The requirements in paragraphs (c)(3) through (6) of this section do not apply to the following types of transactions:
(v) A loan with maturity of 12 months or less, if the purpose of the loan is a “bridge” loan connected with the acquisition of a dwelling intended to become the consumer’s principal dwelling.
(i) An escrow account need not be established for:
(C) A temporary or “bridge” loan with a loan term of twelve months or less, such as a loan to purchase a new dwelling where the consumer plans to sell a current dwelling within twelve months; or
Section 32 (1026.32) (High-Cost Mortgage) Owner-Occupied Rules Apply But the Balloon Payment Rule is Relaxed.
Section 32 itself contains no exemptions for high-cost bridge loans where the creditor is taking a lien on the borrower’s new home (which is considered the principal dwelling). This means that HUD counseling and a HUD Counseling Certificate are required (1026.34(a)(5)) and a creditor is prohibited from financing soft loan fees ((a)(10)). Late fees are limited to 4% ((a)(8)). However the rule does allow a one year balloon payment for bridge loans:
1026.23(d)(1)(i) Balloon Payment
Limitations. A high-cost mortgage shall not include the following terms:
(1)(i) Balloon payment. Except as provided by paragraphs (d)(1)(ii) and (iii) of this section, a payment schedule with a payment that is more than two times a regular periodic payment.
(ii) Exceptions. The limitations in paragraph (d)(1)(i) of this section do not apply to:
(B) A loan with maturity of 12 months or less, if the purpose of the loan is a “bridge” loan connected with the acquisition or construction of a dwelling intended to become the consumer’s principal dwelling; or
The 3 Day Right to Cancel (1026.23) is Preserved for an Under 12 Month Bridge Loan Secured by the Consumer’s Existing Home.
See the discussion above. Because the loan is secured by the consumer’s existing home, the 3 Day Right to Cancel is preserved.
Scenario 3: Lender Takes a Deed of Trust on Future Home Only While Borrower Sells Old Home.
Ability to Repay Rule (1026.43(c)) Does Not Apply to Under 12 Month Bridge Loans: (see discussion above).
Section 35 (1026.35) (Higher-Priced Mortgage) Exempts All Bridge Loans (see discussion above.
Section 32 (1026.32) (High-Cost) Owner-Occupied Rules Apply to Because there is No Exemption for Loans to Acquire a New Principal Dwelling. Keep in mind that a one year balloon is permissible, HUD counseling and certificate are required and you cannot finance soft points and fees.
The Right to Cancel (1023.23) Does Not Apply to a Loan to Acquire a New Principal Dwelling Because it is a “Residential Mortgage Transaction and They are Not Rescindable.”
(f) Exempt transactions. The right to rescind does not apply to the following:
(1) A residential mortgage transaction.
(24) Residential mortgage transaction means 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.
As you can see this area is complex but the good news is that if a broker can master the application of these rules to bridge loans, they will be a good source of safe income. The scariest element of high cost lending—Ability to Repay—is gone. Section 35 (Higher-Priced) Rules do not apply. However, Section 32 rules will apply if the new home is encumbered but without the Ability to Repay risk. One year balloons are also permissible. Remember that If the bridge loan is secured by the borrower’s existing home only, Ability to Repay does not apply. Only the 3 Day Right to Cancel Rule applies.
Since most privately funded bridge loans will fall within Section 32 because of their short duration, the challenges to the broker will be HUD counseling and certificate and more importantly, the inability to finance soft points and fees. HUD counseling can take place over the phone with the borrower and the certificate is a HUD approved form–so that obstacle will not prove too difficult. As for points and fees, those are going to either have to be paid by the borrower in cash or the broker will have to get paid out of the interest income stream by charging a higher interest rate and taking his or her compensation as a larger servicing fee or spread.
© Doss Law, LLP. Attorney advertising materials. These materials have been prepared for educational purposes only and are not legal advice. This information is not intended to create an attorney-client relationship. Consult a knowledgeable lawyer before implementing any of the ideas in this publication.