Business vs Consumer Purpose Lending
Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “Business vs Consumer Purpose Lending.”
Why is the distinction between business and consumer purpose lending important? Because both federal and most state government(s) have created regulations that require special disclosures and notice/reporting responsibilities for lenders when dealing with consumer purpose borrowers. These additional requirements have extreme punitive consequences for any mistakes or deviations by the lender(s) and/or procuring mortgage broker(s). These onerous changes have caused many private money lenders to exit consumer lending all together.
What is a business purpose real estate loan?
Business purpose loans secured by real property are originated where the loan proceeds are used primarily for business purposes. “Primarily used for business” is important. What that means is that a portion of the loan proceeds, more than 50% will be used for business purposes and a portion (less than 50%) of the loan proceeds may or may not be used for consumer purposes.
Consumer purpose loans, on the other hand, are made where loan proceeds are used primarily for personal, family and household purposes.
On the front-end when some borrowers are searching for a loan, they may discover that they can only find lender(s) who makes business purpose loans. They will often construct a narrative to make their loan into “business purpose.” Some are legitimate and some are not. Borrowers who represent the need for a loan as business purpose must provide substantial documentation to that effect. Proper documentation evidencing the business purpose in the brokers file is paramount.
Conflicts in a borrower’s memory may arise about the borrower’s front-end representations about purpose of loan in the event of default. Yesterday’s business purpose borrower may suddenly become a meek and vulnerable consumer who was taken advantage of by the big-bad-wolf mortgage broker. The history of conversations will quickly turn from “I want a business purpose loan,” to “you knew all along that I was really going to use all the proceeds personally and you told me to do it this way.” “You also knew that I could not afford the payments.” A defaulting borrower may conveniently turn on the broker/lender and blame them as “he/she told me to do it.” So, when some borrowers default it is your fault Mr./Ms. mortgage broker.” Blaming others for one’s own default or problems seems to have become the American way.”
The greater the percentage of loan proceeds used for business the safer for the lender and procuring loan broker in the event of default. What I mean by the term “safer” is whether the lender or procuring loan broker could become entangled in an accusation by the borrower that the loan was a really a disguised consumer loan.
Industry participants commonly refer to the “business purpose exemption.” There is not a stated “exemption” in the Truth-in-Lending regulations but rather just “not covered,” under the consumer laws. Common practice is that “not covered” and “exempt” are interchangeable in meaning.
Consumer purpose loans have historically been subject to much greater federal and state government restrictive regulatory oversite. This is the same for 1 to 4 residential unit loans versus commercial or larger multi-tenant buildings. This has led many lenders/mortgage brokers to the decision to exit the consumer purpose lending all together and only engage in lending for business purposes. Many mortgage brokers have found out the hard way that consumer related lending is not worth the risk of legal liability if anything goes wrong. Judges and courts are tremendously biased toward the “perceived less than sophisticated consumer/homeowner parties”. In general, businesspersons in U.S. courts of law, and especially in California are suspected of the wrongdoing until proven innocent. Most highly experienced practitioners will agree!
Any accusation of a perceived infraction of violating Truth-in-lending or other state and federal law, even with little legal basis, could cost a mortgage broker a ton of money for discovery, court costs, and lawyer fees. Their entire career and loss of real estate lending license may be on the line with every single transaction.
Here are few recommendations under the category of best practices:
- Broker should verify that the business purpose portion of the net loan proceeds are disbursed at escrow closing into a business account.
- Obtain a borrower resume’ and/or history of business activities evidencing business purpose.
- The correlation between the consumer’s occupation and redundancy can be verified by a resume. An investor may repeatedly purchase investment real estate for rehabilitation and resale at a potential profit.
- For speculative vertical construction loans, if the security property is residential property of 1 to 4 the loan file should contain a written statement from the borrower’s intent to sell the finished property on the open market, and that he/she does not intend to move into the home as a primary residence.
- Obtain a list of items and dollars to be spent for business related expenses contemplated by the borrower. Written estimates from vendor cost bids are helpful.
Private money or what is referred to as hard money lenders provide an alternative borrowing industry to institutional lenders such as banks and government sponsored lenders (GSEs) such as Fanny Mae and Freddy Mac.
A new set of underwriting standards and loan approval considerations may be required for borrowers who have been subject to difficulty in 2020 from the COVID related fall-out and the changes in real estate related California laws. Borrowers may have a fragmented credit history and perhaps skipped payments due to reduced personal or business-related cash-flow. The “unable to qualify” for bank loans may become more prevalent.
Property owner/borrowers may have taken advantage of payment deferrals based upon lack of payments received from tenants, and/or foreclosure moratoriums, from both state and federal mandates. Borrowers may need loans secured by their real estate for the purpose of catching-up or shoring-up finances of their business enterprise(s), and to renew a good credit status and return to timely payment habits. This almost sounds like a “fresh start loan.”
The lenders/mortgage brokers should obtain a completed borrower’s loan application, financials, credit report and independent third-party appraisal. Bank statements or tax returns with a profit & loss may be helpful. 6 months of business and personal bank statements are usually adequate for private money loans. The procuring lender can visually substantiate available cash flow from the borrower(s), the borrower(s) business, and the subject property for expenses and debt service.
Credit considerations and approval will take on some compassionate analysis of circumstances as well as proving up the borrower’s ability to repay. This will be a delicate balance.
Since many private money lenders are more “equity driven” than “income driven” alternative methods of analysis may be approached. For example, historically many lenders assume that if a borrower has a property with a 60% loan to value and 40% as “protective equity” then the lender may not require much more than an application, independent appraisal, and a credit report. Timely payments and performance of the loan terms are assumed because any borrower who accrues that much equity over time will likely not default in any circumstance. This is referred to as “equity driven lending vs credit and income driven lending.” Somewhere in between is most prudent. We may find that with recently passed laws and new legislation pending loan-to-values and method of analysis will change.
A consumer purpose loan can only be made to a consumer, which is a natural person or a natural person’s family trust. Generally, a family trust is considered a consumer and are therefore covered under federal and state consumer laws.
Since LLC’s, Corporations, and business trusts are typically formed for business purposes loans to these entities are not covered (exempt from consumer disclosure laws). The entity would generally be exempt if used for a legitimate business purpose and is not established to circumvent applicable consumer lending laws.
Consumer purpose laws are driven by the purpose of the borrowed funds not the collateral property borrowed against.
It is natural to confuse “owner occupancy” and “consumer” with whether a loan is covered by Federal the Truth in Lending Act (TILA). RESPA, (Real Estate Settlement Procedures Act), Dodd-Frank, and other federal and state regulatory requirements are also involved. Loans do not have to be owner-occupied to fall under the Truth-in-lending and “ability to repay” requirements.
The determination as to whether a loan falls inside consumer laws is “purpose driven” rather than “occupancy driven.” The means if the purpose of the loan was consumer that it must comply with consumer laws. If a gas station owner who rents his property to a third party borrows money using the gas station as security to consolidate personal and household debts and to improve his owner-occupied home, then it is a consumer loan. This article is educational but not a complete representation of facts or regulations.
All real estate loans should be completed through a closing process with a licensed escrow company and provide for a policy of title Insurance. The lender or mortgage broker handles the regulatory compliance issues and underwriting but escrow and title handle the escrow instructions and settlement procedures and closing statements. Escrow agents have a dual fiduciary between a buyer/seller and a borrower/lender. Borrowers and lenders need to read the narrative escrow instructions, coverages, exceptions, and exclusions to the policy of title insurance. Exceptions and exclusions are things not covered by the polity of title insurance.
For the Technically minded?
Regulation Z was the Federal Reserve Board regulation that implemented the Truth-in-Lending Act (TILA) of 1968. This was all part of the Consumer Credit Protection Act of 1968. The act’s major goal was to provide consumers with better information/disclosures about the true cost of credit, including a calculation of annual percentage rate (APR). APR was calculated to include all cost of borrowing including interest rate, and fees charged. Lenders were required to disclose interest rates in writing, give borrowers a chance to cancel (3 day right of rescission), and provide clearly written disclosures about the loan terms and costs. The intent was to protect consumers from misleading practices by some real estate lending participants. The purpose was so that the consumer could compare total cost between different lenders. Regulation Z and Truth-in-Lending (TILA) are often used synonymously.
An amended Section 32 of Regulation Z was created as part of the Home Ownership and Equity Protection Act of 1994. It amended TILA by establishing requirements of certain loans with high-interest rates and high-fees. This provided for additional requirements to disclose loan terms and annual percentage rates for the borrower’s primary residence, or consumer purpose. Lenders were not able to charge more that 10% above rates on Treasury securities of comparable maturity. Lenders could not charge points and fees of over $435 or 8% of the total loan amount which ever was greater. Other prohibitions were as follows:
- All balloon-payments – where the regular payments do not fully pay off the principal balance and a lump sum payment of more than twice the amount of the regular payments is required – for loans with less than five-year terms. There is an exception for bridge loans of less than one year used by consumers to buy or build a home: in that situation, balloon payments are not prohibited.
- Negative amortization, which involves smaller monthly payments that do not fully pay off the loan and that cause an increase in the total principal debt.
- Default interest rates higher than pre-default rates.
- Rebates of interest upon default calculated by any method less favorable than the actuarial method.
- A repayment schedule that consolidates more than two periodic payments that are to be paid in advance from the proceeds of the loan.
- Most prepayment penalties, including refunds of unearned interest calculated by any method less favorable than the actuarial method. The exception is if:
- the lender verifies that your total monthly debt (including the mortgage) is 50% or less of your monthly income.
- you get the money to prepay the loan from a source other than the lender or an affiliate lender; and
- the lender exercises the penalty clause during the first five years following execution of the mortgage.
The Real Estate Settlement and Procedures Act (RESPA) of 1974, along with subsequent amendments restricted consumer-purpose lending to require special timely disclosures regarding the nature and cost of the real estate settlement process.
Additional subsequent regulations came in the Wall Street Financial Reform and Consumer Protection Act of 2010, (“Dodd-Frank”) which reinforced disclosure requirements and added the requirement to prove up the borrower’s ability to repay. Loans were prohibited where the borrower had no verifiable source of income.
All the new California state laws and compliance have been added on to the Federal legislation of January 2014 loan servicing requirements imposed by the Federal Consumer Financial Protection Bureau (CFPB) which was originated as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010. This is a regulatory nightmare laced with legal liability.
This new post COVID lending environment “The New Reset” may be referred as “re-employment act for government employee bureaucrats, much bigger government, much greater complex regulations, with much greater threat of negative and punitive consequences for any questionable deviations” Also, all these new complex laws constitute a re-employment act for lawyers. With this “New COVID Reset” private money mortgage brokers may discover fewer freedoms in making experiential-based judgment calls. Lenders/mortgage brokers will find a more difficult environment in which to operate as they “wind themselves thought this technical maze” in the uncharted territory of new laws. Operational costs will be higher which will reduce the bottom-line profit. Competent counsel will be required.
Consumer and business purpose lending is made more complex by both state and federal government regulations that are in some cases conflicting. My comments and opinions are not all encompassing. Any owner/borrower or lender/mortgage broker should consult with a highly competent lawyer to guide them to appropriate actions.