Dennis H. Doss
Christopher J. Donovan
We have written many times about consumer bridge loans and the exemption they enjoy from the scary and potentially litigious Ability to Repay (“ATR”) rule embodied in Dodd-Frank. That rule is embodied in the federal Truth-in-Lending Act (“TILA”) and Consumer Financial Protection Bureau regulations. But there are two other consumer mortgage products that also enjoy the same exemption: ground-up construction loans and home equity lines of credit (“HELOCs”) that are higher-priced (Section 35) but not high-cost (Section 32). Both products fit the private money model. This article will touch on both.
Consumer, Principal Dwelling, Home Equity Lines of Credit
Prior to the passage of Dodd-Frank, HELOCs were exempt from the ATR rule. Unfortunately, some lenders abused them (very high rates and points) and there was a significant pushback from borrowers and consequently, the government. Borrowers attacked these abusive HELOCs as sham loans designed to bypass the more rigorous ATR rule in TILA applicable to closed-end loans. Since then, only a handful of private lenders have offered HELOCs.
Dodd-Frank made it clear that a lender is prohibited from masking a closed-end loan as a HELOC to avoid the closed-end loan restrictions on higher-priced and high-cost loans. In other words, HELOCs cannot be offered to evade high-cost laws. In addition, they must have the normal characteristics of a revolving line of credit. Examples of structures would detract from the notion of a line of credit are loans that:
- Are fully drawn at inception, with no unused credit;
- Have a very short draw period;
- Carry high fees for redraws after a borrower pays down a credit line (a form of discouragement); and,
- Have a very short term.
In addition, a lender offering HELOCs should also offer borrowers the alternative of a closed-end loan and actually make closed-end consumer loans. However, you would have to consider ATR to offer a closed-end loan.
The opportunity still exists to make bona fide (loans that avoid the above problems) HELOCs that are exempt from Dodd-Frank’s ATR–if they are not high-cost (Section 32). However, they can be higher-priced (Section 35) and still enjoy the exemption from ATR. In practical terms, that means that using a Average Prime Offer Rate of 3.51% on a 5-year loan, a lender could offer a 1stmortgage HELOC at 10% APR (example, 9% and 4 points) or 2ndmortgage HELOC at up to a 12% APR (example, 10.95% and 4 points). These are good rates for private money. If you go over the higher-priced limits and venture into the high-cost arena, the risky ATR rule for high-cost (Section 32) loans will apply.
The documentation for HELOCs is very different from closed-end loans. First, the lender must use an application disclosure in the federal format (very different from a Loan Estimate). Second, the TILA disclosures are built into the loan agreement itself, which has reasonable restrictions as to content. Since these are consumer loans on principal dwellings, an NMLS license endorsement is required and the right to cancel still applies. HELOCs are exempt from California high-cost law embodied in Financial Code Section 4970.
Consumer, Non-Principal Residence Home Equity Lines of Credit
What about a bona fide, consumer HELOC on a non-principal dwelling, such as a loan on a second home or a rental? The answer is that you can charge whatever you want over whatever term you want, since those loans may exceed the thresholds for high-cost loans. The higher-priced and high-cost rules only apply to loans on principal dwellings, and a consumer can only have one principal dwelling at a time. The ATR rule in 12 CFR Section 1026.43 exempts HELOCs. The only other ATR rule in the regulations used to be in Section 1026.35(e), applicable to higher-cost (Section 35) loans, but it expired in 2014. Remember that an NMLS endorsement is required for non-principal dwelling, consumer residential loans.
Practice Note: HELOCs are meant to be single investor loans that are carefully monitored by the broker that originated them. Someone must make sure draws are made when requested. Thus, the broker must be prepared to fund the draw if his or her investor cannot be located. HELOCs must be serviced by a company with HELOC software because a specific form of monthly statement must be issued to the borrower. We do not recommend fractionalizing a HELOC nor releasing the servicing of it to your average private investor. Your reputation is on the line; it is your most important asset. If a draw is missed by a private investor, a claim could be made against you as the originator. While federal law may exempt you from the ATR rule, common sense and your fiduciary duty dictate that you consider how the borrower is going to repay the loan.
Ground-Up Consumer Construction Loans
Like consumer bridge loans, consumer ground-up construction loans fit the private money model like a glove. They are short-term, one year or less, the borrowers are typically creditworthy, and the yields are in the double digits.
When underwriting a ground-up construction loan, you should consider:
Exit Strategy. First, will this borrower and property qualify for a take-out loan after construction is complete? The borrower must have the verifiable income and credit to qualify for a conventional loan. In addition, the borrower’s equity in the finished home must be enough to qualify for permanent financing.
Cash Reserves. The second consideration is the borrower’s cash reserves. Construction projects are notorious for going over budget. People building custom homes frequently embellish the plans as they see their “baby” coming to life. A permanent lender will want to see cash reserves for take-out financing. Hence, if they are putting their last dime into the project at inception, the loan should be avoided.
Budget. The third consideration, like with all construction loans, is the adequacy of the budget for the intended project. Submit the plans and the budget to a professional construction estimator to determine if there is enough money in the budget to bring the home over the finish line.
Strong Contractor. Lastly, the project will only be successful if the general contractor is reliable. By that we mean, someone with a track record for getting projects built on time and on budget without legal issues (e.g. liens or disputes with clients).
If your loan prospect has passed all these tests, let’s talk legal. For this article, we will only cover California and Federal laws.
NMLS (National Mortgage Licensing System)
Since a ground-up home construction loan is a consumer real estate loan, it must be made or arranged by a DRE real estate broker or a California Finance Lender (or other exempt lender), with an NMLS endorsement.
DRE Construction Restrictions (not applicable to CFL Lenders)
If the loan will be made by a DRE* real estate broker and sold to private investors, or if the broker is using private money to fund the loan, the broker needs to comply with Business and Professions Code 10232.3, which requires:
- $2,500,000 loan cap;
- 100% funding of the loan into escrow at inception;
- Undisbursed funds must be held by a “neutral, independent, escrow agent” (i.e. the broker cannot hold funds);
- Disbursements must follow a draw schedule;
- Disbursements must be preceded with an inspection by an independent architect, general contractor or structural engineer;
- An appraisal must be completed by a qualified/licensed appraiser in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP);
- The loan documentation must describe remedies if there is a default (e.g., good construction loan docs drafted by Doss Law); and
- LTV, based on the finished home, must not exceed 80%.
*These restrictions do not apply to a DRE broker using its own funds and who will not be selling any portion of the loan to a private investor.
Dodd-Frank and TILA
The federal consumer protection laws are very favorable to ground-up consumer construction loans. You must still follow the Dodd-Frank disclosure scheme by providing the Loan Estimate and the Closing Disclosure (following the timing associated with both). To be exempt from the rules for higher-priced loans, high-cost loan, and ATR, the following restrictions must be observed:
- Loan term must be for 1 year or less, but can be renewed beyond that;
- ATR is not required;
- Right to cancel does not apply, unless you are placing an additional lien on an existing home;
- No impounds are required;
- 4% late charge restriction does not apply;
- HUD counseling is not required;
- Points and other lender/broker fees may be financed;
- No HOEPA notice (these loans are exempt from Sections 32 and 35); and,
- Mandatory arbitration clauses are still prohibited.
California High-Cost Loans
California’s high-cost loan scheme, embodied in Financial Code Section 4970 et seq., specifically exempts ground-up construction loans as well as loans over the Fannie Mae conforming loan limit ($453,100 to $679,650 depending on the county of where the home is located). Most construction loans are well over the loan limit.
If you have an appetite for these loans, you could market your ability to do them to local conventional construction lenders, custom homebuilders and to real estate agents in your area. You may also want to track the sale of buildable lots in your area through the MLS and send a letter to the agents with a request to pass your information on to their clients. You can even ask your friendly title company to identify the recent purchasers of lots in your area, so you can write to those buyers directly.
This article is intended as educational material – not legal advice. Consult a knowledgeable lawyer before implementing any of the ideas in this publication.