I. ADJUSTABLE-RATE MORTGAGE CAPS
A. Introduction
Section 226.30 of Regulation Z (See, Truth-In-Lending, 12 C.F.R. Part 226) implements the Competitive Equality Banking Act of 1987 provision requiring caps on adjustable-rate mortgages (ARMs). Creditors that offer ARMs, for either open or closed-end credit, must set a limit on the maximum interest rate that may be charged. Since the law and regulation applies only to dwelling-secured consumer credit, a business purpose ARM loan is not covered, even when secured by a dwelling.
The law does not establish a maximum interest rate: this determination remains within the creditor’s discretion. The law applies to closed-end transactions (such as a traditional second mortgage) or open-end plans (such as home equity lines of credit) entered into on or after December 9, 1987. Creditors are required to specify within their credit contracts, the lifetime maximum interest rate that may be imposed. Failure to comply is treated as a violation of the Truth-in-Lending Act (TILA) and its civil liability and administrative enforcement provisions.
B. The Regulation
The full text of the regulation (Section 226.30 - Limitation on Rates) states:
A creditor shall include in any consumer credit contract secured by a dwelling and subject to the act and this regulation the maximum interest rate that may be imposed during the term of the obligation when --
a. in the case of closed-end credit, the annual percentage rate may increase after consummation, or
b. in the case of open-end credit, the annual percentage rate may increase during the plan.
C. Compliance Notes
Section 226.30 applies to any closed-end credit transaction or open-end credit plan that permits an interest rate change during the term of the obligation. As a result, most dwelling-secured extensions of credit, for which Regulation Z variable-rate disclosures must be given, will be subject to § 226.30.
Variable-rate transactions are also covered in other sections of Regulation Z. The impact of this particular regulation is that dwelling-secured, variable-rate transactions are now required to state the maximum interest rate, either as a specified amount or in any other manner, allowing the consumer to easily ascertain what the lifetime cap will be over the term of the loan.
The following statements are examples of what may be acceptable:
1. The maximum interest rate will not exceed X%;
2. The interest rate will never be higher than X percentage points above the initial rate of Y%; or
3. The maximum interest rate will not exceed X% or the state usury ceiling, whichever is less.
The following statements give examples that may not comply with the regulation:
1. The interest rate will never be higher than X percentage points over the going market rate;
2. The interest rate will never be higher than X percentage points above (a rate to be determined at some future point in time); or
3. The interest rate will not exceed the state usury ceiling which is currently X%.*
The following are examples of loans subject to § 226.30:
1. Dwelling-secured, open-end lines of credit in which the creditor has the contractual right to make interest rate changes during the plan, even if the adjustments apply to new advances only;
2. Renegotiable-rate mortgage instruments, where the creditor is legally obligated to renew the loan upon maturity;
3. Multiple-advance transactions disclosed as a single transaction, if the interest rate on the advances is unknown at consummation (i.e., adjustable-rate construction loan for a principal residence);
4. Refinancings, defined as when an existing obligation is satisfied or extinguished and replaced by a new obligation undertaken by the same consumer, entered into prior to December 9, 1987, of credit obligations that are dwelling-secured and that allow for interest rate changes;
5. Assumptions (entered into prior to December 9, 1987) of credit obligations that are dwelling secured and that allow for interest rate changes. (For purposes of § 226.30, where an obligation subject to this section is assumed and the original obligor is released from liability, the maximum interest rate set on the obligation may be changed as part of the assumption agreement);
6. Credit obligations allowing for interest rate changes to which a security interest in a dwelling is added on or after December 9, 1987; or
7. Dwelling-secured credit obligations to which a variable-rate feature is added on or after December 9, 1987.
If the interest rate may not change during the term of the obligation it would not be subject to § 226.30, as shown by the following types of transactions:
1. Shared-equity mortgages;
2. Fixed-rate multiple advance transactions in which each advance is disclosed as a separate transaction; or
3. Fixed-rate balloon payment mortgages that the creditor may, but does not have a legal obligation to, renew at maturity.
Compliance questions concerning § 226.30 should be directed to your primary federal regulator.
II. ADJUSTABLE-RATE MORTGAGE DISCLOSURES
The Federal Reserve Board (FRB) adopted its ARM regulations amending Regulation Z on December 18, 1987, which became effective on December 28, 1987. The regulations require banks to provide more extensive disclosure information about variable-rate features of closed-end ARMs than was previously required. For state nonmember banks, the FDIC is the enforcement authority for Regulation Z compliance. Also, the Office of the Comptroller of the Currency (OCC) issued its rules amending disclosure requirements for ARMs, effective March 11, 1988. The OCC is the enforcement authority for national bank compliance with Regulation Z. This article highlights these rules, as amended from time to time.
B. Federal Reserve Board Regulation Z: ARMs
1. Scope of Regulation (FRB)
Regulation Z ARM disclosures apply only to transactions secured by a consumer’s principle dwelling. Coverage includes purchase money mortgage transactions and all fixed term, closed-end transactions with a term greater than one year in which the customer is using the principle dwelling as security for a loan.
ARM disclosure requirements do not apply to transactions secured by the consumer’s principle dwelling with a term of one year or less as these transactions are covered by other Regulation Z disclosure requirements [See, § 226.18(f)(1) which provides four disclosures or allows § 226.18(f)(2) or § 226.19(b) to be substituted disclosures]. Also, the disclosure regulations do not apply to a fixed-rate loan agreement secured by the consumer’s principle dwelling that implicitly permits interest rate adjustments by having the note mature on demand or at the end of or in an interval shorter than the term of the amortization schedule (e.g., balloon mortgage).
2. Timing of Disclosures (FRB)
Banks must make two disclosures to eligible ARM customers: (a) initially, at the time an application form is given to the customer or before the customer pays a non-refundable loan fee, whichever is earlier; and (b) subsequently, at loan adjustment periods. Should the customer’s application reach the bank by telephone or through an intermediary agent or broker, the required disclosures may be delivered or placed in the mail not later than three business days following receipt. Subsequent ARM disclosures will simply include statements that the variable-rate features exist and that the required variable-rate disclosures have clearly been given to consumers.
3. Initial Disclosures (FRB)
Under the initial disclosures requirement, the bank must provide the customer with the Consumer Handbook on Adjustable Rate Mortgages, published by the FRB or “a suitable substitute” that, at a minimum, is comparable in substance and comprehensiveness; however, additional information may be included in it.
The bank must also make the following disclosures which provide specific information about all major aspects of the ARMs offered by the bank, stating:
a. that the interest rate payment or term of the loan can change;
b. the index or formula used in making adjustments, and a source of information about the index or formula: banks are required to identify the index to which interest rate changes are tied or provide a brief description of the formula used in calculating changes if no index is used; if the interest rate changes are purely discretionary or are made by an internally defined index, the bank will still need to describe the method of rate changes or state that they are discretionary (e.g., if index values are listed in the Wall Street Journal, the bank could so state to satisfy this requirement);
c. how the interest rate and payment will be determined, including an explanation of how the index is adjusted, such as by the addition of a margin: this requirement may be satisfied by a statement that the interest rate will be based on a specified index plus a margin and that the payment will be based on the interest rate, the loan balance, and the remaining loan term;
d. that the customer should ask about the current margin value spread and interest rate;
e. any interest discount feature and a statement that the customer should ask about the amount of the interest rate discount;
f. the frequency of interest rate and payment changes;
g. any rules relating to changes in the index, interest rate, payment amount, and outstanding loan balance including, e.g., an explanation of interest rate or payment caps, negative amortization, and interest rate carryover;
h. At the bank’s option, either of the following disclosures:
(1) a 15 year historical example, based on a $10,000 loan amount, illustrating how payments and the loan balance would be affected by interest rate changes implemented according to the terms of the loan program: the example must reflect the most recent 15 years of index values; the example must also reflect all significant loan program terms, such as negative amortization, interest rate carryover, interest rate discounts, and interest rate and payment limitations that would be affected by the index movement during the period;
or
(2) a statement that the periodic payment may substantially increase or decrease, together with a maximum interest rate and payment based on a $10,000 loan amount: the maximum rate/payment must be calculated based on an initial rate (index value plus margin, adjusted by the amount of any discount or premium) that was in effect within one year before the disclosure is made -- in addition, the lender must disclose the month and year this initial rate was in effect and include a statement that the periodic payment may increase or decrease substantially depending on changes in the rate.
i. how the customer may calculate the payments for the loan amount to be borrowed based on the most recent payment shown in the historical example;
j. the maximum interest rate and payment for a $10,000 loan originated at the most recent interest rate shown in the historical example assuming the maximum periodic increases in rates and payments under the program; and the initial interest rate and payment for that loan;
k. the fact that the loan program contains a demand feature;
l. the type of information that will be provided in notices of adjustments and the timing of such notices; and
m. a statement that disclosure forms are available for the creditor’s other variable-rate loan programs.
Disclosures need not be transaction-specific, thus, banks may preprint disclosures for each ARM program, updated annually because of the historical example provision. If an ARM program changes(i.e., whenever any of the facts required to be disclosed changes), new disclosures are required.
4. Subsequent Disclosures (FRB)
Subsequent disclosures are required when an ARM loan rate is adjusted, regardless of whether a payment change actually results.
The subsequent disclosures must be given at least once each year during which an interest rate adjustment was implemented without an accompanying payment change. If the rate adjustment results in a change in the amount of the payment, then the regulation requires a new disclosure at least 25, but less than 120, calendar days before a payment at a new level is due. In either case, the following disclosures, as applicable, must be delivered or placed in the mail:
a. the current and prior interest rates;
b. the index values upon which the current and prior interest rates are based;
c. the extent to which the bank has foregone any increase in the interest rate, e.g., if the new index plus margin would exceed an interest rate adjustment cap;
d. the contractual effect of the adjustment, including the payment due after the adjustment is made and a statement of the loan balance; and
e. the payment, if different from that stated in d., above, that would be required to fully amortize the loan at the new interest rate over the remainder of the loan term.
5. Tables and Sample Disclosures (FRB)
FRB staff compiled tables of 15 year histories of interest rate indexes and drafted model clauses and sample disclosures which are included in Regulation Z, Appendix H. Copies of selected model clauses can be found at http://www.consumerfinance.gov/eregulations/1026-H/2014-25503_20150801.
C. Office of the Comptroller of the Currency ARM Regulation
1. General (OCC)
The OCC rule repealed the old ARM disclosure provisions, replaced with a rule providing that the FRB’s Regulation Z applies for consumer credit transactions. Before the final rule, disclosure requirements varied among the regulators, thus restricting national banks buying ARMs in the secondary market to loans that complied with the OCC’s prior rules.
2. ARM Definition (OCC)
An adjustable-rate mortgage loan is defined in § 34.20 as any extension of credit made to finance or refinance the purchase of and secured by a lien on a one-to-four family dwelling, including a condominium unit, cooperative housing unit or residential manufactured home, where the lender, pursuant to an agreement with the borrower, may adjust the rate of interest from time to time. An ARM loan does not include fixed-rate credit extensions payable at the end of a term that, when added to any terms for which the bank has promised to renew the loan, is shorter than the term of the amortization schedule.
NOTE: ARM loans may be made for business, commercial, investment, or agricultural purposes, without Regulation Z consumer credit disclosures.
3. Authorization (OCC)
Section 34.21 permits national banks and their subsidiaries to make, sell, purchase, participate in, or otherwise deal in ARM loans and interests therein without regard to any State law limitations on those activities.
4. Purchase of Loans Not in Compliance (OCC)
National banks may also purchase or participate in ARM loans not made in accordance with the OCC ARM regulation, except that ARM loans purchased by national banks through their affiliates or subsidiaries must be in compliance with the OCC ARM regulation.
5. Index (OCC)
If the adjustable-rate mortgage loan is a consumer credit loan, the loan documents shall specify an index to which changes in the interest rate charged on an adjustable-rate mortgage loan shall be linked. This index shall be readily available to and verifiable by the borrower, and beyond the control of the bank. A bank may use as an interest rate index any measure of market rates of interest which meets these requirements. The index for an adjustable-rate mortgage loan may be either single values of the chosen measure or a moving average of the chosen measure calculated over a specified period. The bank may increase the interest rate in accordance with the loan documents specifying the amount of the increase and the times at which, or circumstances under which, it may be made. The bank may decrease the interest rate at any time. See, § 34.22.
6. Prepayment Fees (OCC)
A national bank offering or purchasing ARM loans may impose fees for prepayments notwithstanding any State law limitations to the contrary. Under § 34.23 prepayments do not include: (a) payments exceeding the required payment amount to avoid or reduce negative amortization; or (b) principal payments, in excess of those necessary to retire the outstanding debt over the remaining loan term at the then-current interest rate, that are made pursuant to rules governing the determination of monthly payments contained in the loan documents.
7. Maximum Interest Rate Limitations (OCC)
All consumer credit adjustable-rate mortgage loans originated on or after December 9, 1987, shall include a limitation on the maximum interest rate that may apply during the term of the loan. Variable interest rates on ARM loans may be tied to the bank’s prime rate when such loans are made for business, commercial, investment, or agricultural purposes. Note again, however, that national banks continue to be subject to the disclosure requirements for consumer ARM loans as contained in Regulation Z. Also excluded from the ARM definition are fixed-rate extensions of credit payable on demand or fixed-rate extensions of credit payable either without interim amortization, or at the end of a term that is shorter than the term of the amortization schedule.
8. Due-On-Sale Clause Regulation (OCC)
The rule also revised OCC regulations concerning “due-on-sale” clauses in real estate loans.** The most recent revisions occurred on April 19, 1996. The definition of a “Due-on-sale clause” is found in § 34.2:
. . .any clause that gives the lender or any assignee or transferee of the lender the power to declare the entire debt payable if all or part of the legal or equitable title or an equivalent contractual interest in the property securing the loan is transferred to another person, whether by deed, contract, or otherwise.
Under § 34.5, a nation bank may make or acquire a loan or interest therein, secured by a lien on real property, that includes a due-on-sale clause. Except as set forth in 12 U.S.C. 1701j-3(d) (which contains a list of transactions in which due-on-sale clauses may not be enforced), due-on-sale clauses in loans, whenever originated, will be valid and enforceable, notwithstanding a State law limitations to the contrary. The term real property includes residential dwellings, such as condominium units, cooperative housing units, and residential manufacture homes.
III. COMPLIANCE NOTE: LOAN SERVICING ERRORS IN ARMS
A General Accounting Office report estimated that as many as one of every four borrowers who bought homes with adjustable-rate mortgages may be receiving incorrect billings each month because of bank errors in calculating their interest rates during the period reviewed in the report. Some borrowers are paying too much while others are paying to little.
As a result of this report, regulators and borrowers were concerned about how these ARMs are serviced. Left uncorrected, loan servicing errors could result in growing civil liability for lenders both under Regulation Z and the National Affordable Housing Act (NAHA). Class action lawsuits have been filed against financial institutions alleging the mishandling of ARMs.NAHA established procedures for responding to certain written requests or allegations of errors in ARM loans and provides liability for damages. If your bank currently offers ARMs or has done so in the past, you should be sensitive to this issue and corrective steps should be considered if a problem is uncovered. The FDIC warned that “errors have most frequently been found on consumer loans, home equity lines of credit and credit cards.”
The most common interest rate adjustment errors can be grouped into a few broad categories: (1) use of the wrong index or margin upon which rate adjustments are based; (2) use of the wrong date for making adjustments; (3) incorrect or unauthorized rounding of the interest rate; (4) violations of the caps on interest rate adjustments; (5) computer system that are incapable of handling an institution’s adjustable-rate product; and (6) computer programs that use the wrong adjustable-rate guidelines.
Regulators have recommended the following steps to help identify, correct or prevent problems with ARMs:
1. Review internal and external loan servicing procedures to ensure that proper controls are in place to follow the adjustments required in loan contracts;
2. Inspect paid-up and outstanding adjustable-rate loans to ensure that they have been administered properly;
3. Make appropriate corrections and payments to customers who may have been overcharged;
4. Retain documentation of the indexes used in making interest rate adjustments. Section 226.25(a) of Regulation Z specifies a two-year document retention period; and
5. Train employees in identifying adjustable-rate loan servicing problems and responding to inquiries from borrowers.
Any questions about identifying or correcting problems with ARMs should be directed to the FDIC’s Division of Supervision office in your region.
If you review past rate adjustments and discover errors, the primary issue to be dealt with is whether voluntary reimbursement should be undertaken. It is doubtful that every failure to service an ARM properly results in a violation of TILA. Some of these errors may be technical in nature and not cause any actual damages to the customer.
Nevertheless, once servicing errors have been discovered, careful consideration should be given to whether TILA reimbursement would be beneficial.
Under § 130 of TILA, a creditor may limit liability for damages if, within 60 days of discovering an error and prior to institution of a suit or the receipt of written notice of the error from a borrower, it (1) notifies the borrower of the error; and (2) makes whatever adjustments are necessary to assure that the borrower will not be required to pay an amount in excess of the charge actually disclosed, or the dollar equivalent of the annual percentage rate actually disclosed, whichever is lower.
Based on the foregoing, it is essential that the bank institutions give immediate attention to the issue of erroneous rate adjustments. Establish appropriate procedures for adjusting rates on ARMs and handling allegations of past errors.