Update of FHA Loan Issue

As reported in the September 28 edition of the Mortgage Banking Update, the American Bankers Association, Consumer Mortgage Coalition and Mortgage Bankers Association sent a letter to the Federal Reserve and other regulators advising of an issue under the new Truth in Lending Act (TILA) rules that could significantly impact Federal Housing Administration (FHA) lending. The Fed’s director of the Division of Consumer and Community Affairs issued a letter dated September 29 to the Department of Housing and Urban Development (HUD) addressing the issue raised by the trade groups.

The new TILA rules became effective on October 1, and the trade groups expressed concern about a prohibition applicable to a new category of closed-end mortgage loans created under the rules that are called higher-priced mortgage loans (HPMLs). Subject to a few exceptions, a mortgage loan is a HPML if it is secured by the consumer’s primary dwelling and the annual percentage rate equals or exceeds a certain threshold. The threshold is 1.5 percentage points or 3.5 percentage points above the average prime offer rate for first-lien loans and subordinate-lien loans, respectively. The average prime offer rate is a rate computed by the Fed for fixed-rate loans with various terms to maturity and adjustable-rate loans with various initial-fixed interest periods.

As of October 5, the average prime offer rate for a 30-year fixed-rate loan was 5 percent. Based on this rate, a first lien 30-year, fixed-rate mortgage loan with an annual percentage rate of 6.5 percent or higher would be an HPML.

Among other restrictions, if a loan is an HPML the loan terms may not provide for a prepayment penalty that can be imposed more than two years after the loan is closed. The trade groups advised that the prepayment penalty restriction presents an issue with FHA loans.

FHA loans often are placed in pools that back securities guaranteed by Ginnie Mae. If a loan is prepaid in full during a month, Ginnie Mae requires that investors receive interest through the end of the month. As a result, many FHA loans provide that if a full prepayment is made on a date other than an installment due date, the borrower may be required to pay interest through the end of month. If the servicer does not collect the interest from the borrower, it would have to pay the interest out of its own funds.

The commentary to the TILA rules provides that a requirement for the borrower to pay interest after the date of a full prepayment is deemed to be a prepayment penalty. The treatment of a requirement to pay interest after a full prepayment as a prepayment penalty, thus, presents an issue with FHA loans in view of the HPML restriction on prepayment penalties.

The Fed’s director notes in the letter to HUD that FHA uses the monthly interest accrual amortization method and, as a result, if the consumer’s prepayment occurs 10 days before the payment due date, the consumer owes the same amount of interest as if the prepayment occurs on the payment due date. The director then states “You [HUD] have advised the Board that, for federally-insured loans, due to the monthly interest accrual amortization method, HUD has not considered the payment of interest after the prepayment date as a prepayment penalty and has advised lenders that they need not disclose this practice as a prepayment penalty.”

Recent HUD actions reflect that it does not view the requirement to pay interest after a full prepayment with an FHA loan as a prepayment penalty. The new forms of good faith estimate and HUD-1 under the Real Estate Settlement Procedures Act (RESPA) rule that becomes effective on January 1, 2010 provide for the disclosure of whether the loan has a prepayment penalty. In a version of the frequently asked questions (FAQs) being issued by HUD to provide guidance on the rule, HUD advised that the requirement with an FHA loan that the consumer pay interest through the end of the month, even if the loan prepays earlier in the month, is not a prepayment penalty. Subsequently, HUD removed the FAQ without explanation, and it is believed that HUD did so based on a discussion with the Fed.

Apparently the Fed staff had a change of heart. The director advises in the letter that the portion of the commentary regarding prepayment penalties “does not address the specific situation involving loans that generally use the monthly interest accrual amortization method.” The director then states:

In light of the guidance given by HUD regarding the payment of interest after the prepayment date, and the fact that the Board staff commentary on this issue does not expressly address this issue in the context of monthly interest accrual amortization, the Board staff believes that lenders that use such an interest accrual method discussed above may continue to follow that practice. Lenders that engage in this practice would not be required to treat the interest charged from the date of prepayment until the next installment due date as a prepayment penalty for any purpose under Regulation Z.

This is interesting. When the commentary provision was adopted in 1986, in the preamble the Fed staff, in noting an example of a requirement to pay interest after a prepayment, expressly stated that “under regulations of the Department of Housing and Urban Development (24 CFR Parts 203, 213, 222, and 234), a lender who accepts prepayment in full on a date other than the installment due date may assess a charge for interest to the end of the month.” But now the director is asserting that the commentary provision does not address the monthly interest accrual amortization method used with FHA loans.

The director concludes the letter by stating that “creditors may rely on this letter as an official interpretation of Regulation Z and, under TILA, liability will not apply to actions taken in good faith reliance on the guidance set forth in this letter, to the same extent as if this guidance were set forth in the commentary to Regulation Z.”

Lenders are advised to confer with their counsel, and also with their investors regarding whether the investors will consider this guidance sufficient to purchase FHA loans that are HMPLs.