Chapter 12 The Loan and the Consumer

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Chapter 12The Loan and the Consumer

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The Truth-In-Lending Act (TILA)

• This chapter deals with the following two topics
  
• Consumer protections when it comes to borrowing,
  esp. as provided in the Truth-In-Lending Act
  (TILA), and
• The processes of loan application and loan
  underwriting.
• The Truth-In-Lending Act (actually named the
  Federal Consumer Credit Protection Act) was
  enacted in 1968, and amended several times since,
  with the purpose of requiring lenders to
  adequately inform borrowers of the credit
  obligations they are taking on when they borrow
  money.
• The act applies to both consumer loans and
  residential mortgage loans.
• The main purpose of the act is to provide
  sufficient disclosure of the cost of credit so
  that borrowers can make informed borrowing
  decisions.

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The Truth-In-Lending Act (Cont.)

• The Board of Governors of the Federal Reserve
  System was given the authority to set standards
  and to implement the Act.
• In 1969, the Board issued Regulation Z, which
  specifies the rules and the regulatory
  requirements of the act.
• A Revised Regulation Z was issued in 1982
  following enactment of amendments to the TILA in
  that year.

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The Truth-In-Lending Act (Cont.)

• The TILA requires certain disclosures (as spelled
  out by Reg Z), both in public advertisements and
  to borrowers as part of the loan application
  process.
• The act applies to anyone offering credit terms
  to the public, with the following exemptions.
• Credit extended for agricultural, business, or
  commercial purposes is exempt from the
  requirements of the act.
• The act applies to mortgage loans for 1-4 unit
  residential property. Loans for residential
  property in excess of four units are considered
  commercial loans.
• Credit of more than 25,000 secured by personal
  property is also exempt, unless the property is
  the principal residence of the borrower, such as
  a mobile home.

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The Truth-In-Lending Act (Cont.)

• The five most important disclosures involve the
  cost of credit. These five disclosures are
• Amount financed the amount of credit provided
• Amount of any required down payment how much is
  it, if any
• Finance charge the total dollar cost of the
  credit, including interest over the loan term,
  discount points, loan origination fees, loan
  service fees, escrow account charges, mortgage
  insurance premiums, and other costs of the loan
• Annual percentage rate (APR) the annual cost of
  borrowing taking into account the loan interest
  rate and all other charges made by the lender for
  the loan
• Total payments the number of monthly payments,
  and the total sum of the payments, or, in the
  case of credit sales, the deferred sales price

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The Truth-In-Lending Act (Cont.)

• If an advertisement by anyone advertising as a
  supplier of consumer credit includes any one of a
  number of trigger terms, then all significant
  terms of credit must be included in the ad.
• An exception to this rule is the annual
  percentage rate, or APR. If the annual
  percentage rate appears in the ad by itself, this
  does not trigger the requirement of full
  disclosure of all loan terms.

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Triggering Items and Disclosures
Triggers disclosure of all five of the following
Mention of any of these

• Cash price or the amount of the loan
• Amount of down payment (or none, if none)
• Number, amount, and frequency of payments
• Annual percentage rate (APR)
• Total payments or deferred payment sales price

• Down payment
• Any payment
• Number of payments
• Period of payments
• Amount of any finance charge, or even a
  statement to the effect no charge for credit

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The Truth-In-Lending Act (Cont.)

• The act also requires lenders to make a number of
  disclosures to borrowers, in writing, about the
  loan. The disclosures must be made before the
  transaction is completed (closed). They normally
  accompany the loan commitment information sent to
  the borrower to examine before loan closing.
• In addition to the five major items listed above,
  a number of other disclosures, which are listed
  in the Jacobus text (p. 204), such as prepayment
  penalties, late-payment charges, rebates,
  detailed information about the features of
  adjustable rate loans, and more, must be made in
  a disclosure statement given to borrowers.
• The lender must also give the borrower a
  statement within 3 days after a loan application
  is made showing a complete breakdown of all loan
  costs.

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The Truth-In-Lending Act (Cont.)

• For a number of loan transactions, the borrower
  must also be informed of a right to rescind
  (i.e., cancel) a loan agreement up to 3 business
  days (which includes Saturday) after signing the
  loan papers.
• In other word, a borrower has the right to back
  out of a loan agreement about which he or she has
  second thoughts.
• The right to rescind does not apply to credit
  used to acquire a principal residence.

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Annual Percentage Rate (APR)

• The Annual Percentage Rate (APR) is a way of
  informing the borrower of the effective cost of
  the loan by combining the loan interest rate with
  the other loan costs, including discount points,
  loan origination fees, mortgage insurance
  premiums, and tax service fees, into a single
  figure expressed as an annual rate. The
  resulting rate approximates the true annual cost
  of the loan.
• Although expressed as a rate, the APR is not an
  interest rate per se.
• The APR is a measure of the true, or effective,
  cost of a loan taking into account the interest
  rate and other loan costs.
• The interest rate is the rental charge per period
  for the use of money. It is the period cost of
  borrowed money.

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Annual Percentage Rate (Cont.)

• Calculation of the Annual Percentage Rate (APR)
  assumes that a loan is held for its full term,
  i.e., not paid off early.
• Thus, whenever loan fees are charged, the APR
  will be lower than the true expected borrowing
  costs when the loan is paid off early.
• In other words, when points and other loan fees
  are charged, the effective borrowing increases
  with early repayment, but this is not reflected
  in the APR.
• The Truth in Lending Act requires that the APR be
  disclosed to the borrower in a residential
  property transaction prior to the loan closing.
• The APR is not required to be disclosed to a
  commercial or investment property borrower
  because these borrowers are assumed to be
  sophisticated knowledgeable buyers able to
  calculate and understand their own borrowing
  costs.

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Process of Obtaining a Real Estate Loan

• Before originating mortgage loans, lenders go
  through a process of loan approval.
• The process of loan approval refers to the steps
  involved in evaluating a loan request (a loan
  application) for the purpose of deciding whether
  to accept it, reject it, or modify it.
• Underwriting the requested loan is an important
  aspect of the process of loan approval.
• Underwriting is a process of analyzing the
  potential default risk of a loan applicant and
  the value of the property serving as collateral
  for the loan, and determining the appropriate
  target yield (effective interest rate) for
  assuming the risk.
• Default risk is the potential loss to the lender
  resulting from a failure of the borrower to make
  timely loan payments and from the failure of a
  foreclosure sale to cover the loan amount and the
  foreclosure costs.

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Process of Obtaining a Real Estate Loan
(Continued)

• The purpose of loan underwriting is to manage
  default risk by taking precautions to minimize
  the chance of borrower default, and to insure
  that, if default occurs, there is sufficient
  value in the property serving as collateral to
  recover the loan and the foreclosure-related
  costs.
• The following five phases are involved in
  financing real estate with a loan
• Loan application
• Borrower and Property Analysis
• Loan processing
• Loan closing
• Loan servicing

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Loan Application

• The lending process begins with the prospective
  borrower completing a lenders loan application
  form.
• Most lenders today use the joint FNMA-FHLMC
  standard application form, which is referred to
  as FNMA 1003.
• The application asks for information about the
  borrower his/her financial status, employment
  history, etc.
• It also asks for information about the property.
• Once the application is complete the lender uses
  it as a screening device to determine whether the
  borrower and the property meet the lenders
  requirements
• If it appears that the borrower and the property
  are going to be acceptable, then the analysis
  phase begins.

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Borrower Analysis

• The analysis phase involves the processes of
  qualifying the borrower and qualifying the
  property.
• Qualifying the borrower entails ensuring that the
  borrower has the ability and the character to
  make the payments on the mortgage loan. In other
  words, the lender wants to analyze the borrowers
  capacity to pay and his/her willingness to pay.
• Qualifying the borrower is largely based on a
  professionally compiled credit report and a
  credit score (called a FICO score) for the
  applicant.
• The three major credit reporting agencies
  Equifax, Experian, and TransUnion issue FICO
  scores. A FICO score is a single number
  summarizing a borrowers credit standing.
• Generally, to obtain an A rating, and the best
  loan terms, the applicants credit score must be
  at least 680 to 700. A credit rating of
  approximately 740 is needed for an A.
• Extenuating or special circumstances may be taken
  into account in addition to the borrowers credit
  report.

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Borrower Analysis (Cont.)

• Qualifying the borrower also involves verifying
  the information provided on the application.
  Employment and income are verified, as are
  checking and savings accounts, and other reported
  information.
• In addition, qualifying the borrower involves
  applying payment-to-income ratios.
• One ratio is the housing expense ratio. This is
  the ratio of monthly housing expense to gross
  monthly income. Housing expense is defined as
  principal, interest, property taxes, and hazard
  insurance premiums. For condos, homeowners dues
  and assessments would be included. The currently
  accepted ratio value is 28, but in Calif. it is
  commonly extended to 30.
• A second ratio is total long term debt ratio.
  This is the ratio of housing expenses plus
  long-term monthly debt payments to gross monthly
  income. This ratio value should be between 33
  and 38 of gross monthly income.
• When all of the borrower analysis is complete,
  the lender then makes a determination about the
  credit worthiness of the borrower.

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Property Analysis

• There are two aspects to qualifying the property.
• Qualifying the title Involves an examination of
  the title for clouds on the title (title defects)
  that could interfere with the marketability of
  the property. Lenders want marketable property
  as security for loans.
• To assure the quality of the title, lenders today
  generally require the borrower to obtain a
  lenders title insurance policy.
• Qualifying the collateral value The lender
  wants to be sure that there is sufficient value
  in the property to cover the loan amount and
  foreclosure costs if the property has to be sold
  in a foreclosure sale.
• This assurance is provided primarily by means of
  an appraisal of the property by a staff appraiser
  or by an independent fee appraiser.
• An appraisal is an estimate of value.
• Real estate appraisers must be state certified.
• In commercial and investment property loans, the
  cash flows produced by the property are also
  analyzed to assess their ability to meet the
  required loan payments.

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Loan Processing, Closing, and Servicing

• Processing involves drawing up the loan papers,
  preparing disclosure forms, and issuing
  instructions for the escrow agent.
• Closing involves signing all of the loan papers,
  transferring and recording documents as
  appropriate, disbursing funds, and other actions
  to finalize the loan transaction.
• Servicing involves the record-keeping and payment
  collection process once the loan is in force.
  Many lenders do their own servicing, while other
  lenders pay independent mortgage companies or
  loan servicing firms to handle the paperwork of
  collecting and processing the loan payments.

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Redlining

• Refusing to make loans in certain areas.

No Loans!



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Subprime Loans

• Borrowers with a risk rating of A (FICO scores
  of roughly 680 or higher) are considered prime
  borrowers. These get the best loan terms.
• Loans to borrowers with a risk rating below A
  are referred to a subprime loans. Loans to
  subprime borrowers are sometimes referred to as
  BC loans.
• Subprime loans are more risky than prime loans.
  Because the risk of default is higher, subprime
  borrowers pay more.
• Such loans come with higher interest rates and
  higher loan fees.
• Subprime borrowers may also face more restrictive
  loan terms, such as prepayment penalties and
  large down payment requirements.
• Subprime borrowers may refinance up into the
  prime market (to A Credit) in a few years
  providing they keep up a good payment history.
• The subprime category has A- to F categories.

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Fair Credit Reporting Act (1992)

• This act was intended to assure that consumer
  credit reporting is fair and accurate. It
  applies only to credit extended to individual
  consumers, not to credit extended for business
  purposes. It is administered and enforced by the
  Federal Trade Commission (FTC).
• If a loan is rejected because of information in a
  credit report, this act requires that a borrower
  be notified of the name and contact address of
  the credit agency.
• The borrower then has the right to obtain
  information that the credit agency has about the
  borrower that led to the rejection, and to
  challenge any information that the borrower
  thinks is erroneous, or to provide explanatory
  comments pertaining to other harmful information.
  
• If an error is found in the borrowers credit
  file, the credit agency must remove or correct
  it.
• California has a similar act called the
  California Consumer Credit Reporting Agencies
  Act. This act requires that a credit reporting
  agency disclose file information to a consumer
  upon request.