Business purpose loans are nontraditional mortgage loans where a borrower uses loan proceeds for a non-consumer purpose. A non-consumer purpose means any loan in which the proceeds are NOT primarily used for personal, family, or household use. There is a common misconception that the primary question in making these loans is whether the property used as collateral is “owner-occupied.”
But, the more important question is whether the loan’s purpose is truly a “business purpose,” rather than “consumer” in nature. The purpose of the loan is the decisive factor in whether the loan is exempt from most federal consumer protection regulations. Simply put, if a loan is correctly classified as “business purpose,” it is subject to far less regulation at the federal level.
Notably, business purpose loans are exempt from requirements mandated in the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act (RESPA). However, many mortgage lenders and their counsel fail to understand that other federal consumer protection laws still apply. This article will provide the reader an opportunity to understand which regulations do and do not apply to business purpose loans.
Two Major Exemptions for Business Purpose Loans: TILA and RESPA
Most of the federal legislation governing mortgage lending is covered in the TILA and RESPA. These Acts set mandatory standards, procedures, and disclosures for lenders to follow. Specifically, TILA requires disclosure of certain credit terms, and RESPA requires standards for closings and fee/cost disclosures. Business purpose loans are exempt from the requirements imposed by both TILA and RESPA.
This is because TILA covers “consumer credit transactions” which are defined as “credit offered or extended to a consumer primarily for personal, family, or household purposes.” Additionally, TILA and RESPA exempt “[a]n extension of credit primarily for a business, commercial or agricultural purpose.” Most of the operative provisions of the acts are further limited in their application to “dwellings” which is defined as “a residential structure that contains one to four units, whether or not that structure is attached to real property.”
Practically, because business purpose loans are exempt from TILA and RESPA, when lenders make these loans they do not need to: (i) comply with federal requirements to verify the borrower’s ability to repay the loan, (ii) issue TRID disclosures, or (iii) comply with RESPA’s loan servicing requirements. However, various federal consumer laws still apply. It is important lenders are aware of and comply with the legislation discussed in the following section.
The Federal Consumer Laws Often Ignored by Lenders, But Applicable to Business Purpose Loans
The Equal Credit Opportunity Act (ECOA) (Regulation B)
ECOA prohibits discrimination and sets procedures for extending credit and communication with credit applicants. Regulation B implements ECOA and contains additional requirements.
ECOA requirements are applicable to business purpose loans because the statute explicitly states “all creditors” are within its scope, and the official interpretation notes its applicability to “commercial as well as personal” credit. The notable requirements set standards concerning (i) appraisals, (ii) discrimination, and (iii) adverse action letters.
Appraisals
Generally, lenders must provide all written appraisals and valuation to a credit applicant, where the applicant is applying for a loan secured by a first lien on a dwelling. This is a requirement whether the lender does or does not approve the applicant’s request for credit, or whether the application is incomplete or withdrawn. Lenders must provide applicants with a notice of their right to these copies within three business days of the application’s submission.
The actual copies must be provided promptly after the valuations are completed, or at least three days before the loan closes, and be provided at no additional cost to the applicant. However, applicants may waive the timing requirement, and agree to receive copies at or before account opening.
As a general recommendation, lenders can include a notice of right to appraisal and waiver of the timing requirement in the loan application package, and then provide the borrower with their appraisal either at the closing table or when they are notified they will not be moving forward with the loan. The key takeaway here is that a lender is obligated to provide the appraisal or other valuation without the borrower requesting this information.
Discrimination
ECOA prohibits discrimination with respect to any aspect of a credit transaction, based on race, color, religion, national origin, sex, marital status, age, and whether an applicant’s income comes from a public assistance program. Again, because ECOA and Regulation B apply to “all creditors” and “commercial and personal” credit, business purpose loans are within the scope.
That being said, the nature of most business purpose lending companies is to evaluate whether to extend credit based on factors like the type of collateral, the borrower’s credit score, and the borrower’s experience relevant to the use of the proceeds. Lenders should take care to ensure that their underwriting guidelines follow those and other similar non-discriminatory reasons for deciding to extend credit. In addition, lenders should look at the types of loans they have extended and denied in the past to ensure that due to evaluating the location of the collateral that they are not unintentionally redlining or otherwise avoiding lending in areas that could lead to a claim that the lender has discriminatory practices.
Adverse Action Letters
An “adverse action” occurs when a lender denies or revokes credit, changes the term of credit, or refuses to grant credit. An “adverse action” does not include a lender’s refusal to extend additional credit under a current arrangement where the applicant is delinquent, or when the requested credit is more than a previous credit limit. ECOA requires lenders to provide applicants/borrowers with a notice stating the reasons for an adverse action whenever an adverse action is taken.
The notification must be in writing, and received by the borrower within thirty days. For borrowers with gross revenue over one million the prior year, lenders may notify of adverse actions verbally or in writing within a reasonable timeframe, rather than the thirty-day written notice requirement for consumer or small business applicants. The best way to easily implement this requirement is to provide the borrower with a notice upon receipt of an application that if their application is denied they have the right to request the statement of reasons for denial.
This will place the onus on the borrower to ask for the reasons of denial, and lender will only need to provide adverse action letters when requested. Alternatively, the lender can make it a policy to send a formal adverse action letter every time such action is taken in order to comply with the statute.
The Home Mortgage Disclosure Act (HMDA)
HMDA requires certain financial institutions to collect, report, and disclose aspects of their mortgage lending activity. In 2018, HMDA was amended to modify the types of lenders, transactions, and data included, as well as the processes for reporting and disclosing. Notably, HMDA now applies to closed-end mortgage loans, which are defined as “an extension of credit that is secured by a lien on a dwelling.”
The definition of “dwelling” is now expanded beyond a 1-4 family residential structure under HMDA, and includes “a detached home, an individual condominium or cooperative unit, a manufactured home or other factory-built home, or a multifamily residential structure or community.” Because HMDA’s definitions focus on property type rather than loan purpose, HMDA now covers lenders making business purpose loans to developers of residential housing.
Specifically, HMDA applies to lenders who made at least twenty-five closed-end mortgage loans in each of the two the last two years, OR one hundred open-end credit lines in each of the two last years. HMDA requires lenders making the applicable business purpose loans to prepare a Loan Activity Register including certain data to the Consumer Financial Protection Bureau (CFPB). There are over one hundred fields that need to be completed and reported to the CFPB for each applicable transaction.
The reporting is problematic for private lenders, because it requires data points with certain options that are not applicable to business purpose loans. For example, the ethnicity/race/sex/age of the applicant or borrower must be reported, which creates confusion when a borrower or applicant is an entity. Additional data points to report include the date of application, the type of loan, the property type, and many more.
In order to comply with these requirements, lenders will need to revise their loan applications to ensure they are capturing the relevant field data in the application process, including the ethnicity, gender, and age of the borrower (even when it seems inapplicable). A manual revise of the application to cover those fields is possible.
In the alternative, many lenders use a modified 1003 as their base loan application, which is supplemented to better suit business purpose loans. After the revisions to HMDA, an addendum to the 1003 was issued which adds an extra page to the application and requests all relevant HMDA data from the applicant.
At a minimum, lenders should include this page in their loan applications to collect the data they will need to comply with annual HMDA reporting. When completing the annual reporting, there are many software providers that can easily collate the data and complete the reports for lenders. An example is QuestSoft, which is software made specifically for HMDA reporting.
The Fair Housing Act
The Fair Housing Act prohibits discrimination based on sex, familial status, race, color, religion, national origin, or disability for transactions involving “dwellings.” The Act defines “dwelling” as any building occupied or intending to be occupied as a residence by one of more families, or land sold for the construction of such a building.
Family includes a single individual. Because the transactions covered are based on property type rather than purpose, business purpose loans are within the scope of the Fair Housing Act.
The discriminatory actions prohibited by the Fair Housing Act are also prohibited by the ECOA, with the former focused on housing transactions and the latter including all credit transactions. Therefore, a lender seeking compliance with ECOA requirements will likely comply with Fair Housing Act requirements.
The Fair Credit Reporting Act (FCRA)
The FCRA regulates the preparation, distribution, and use of credit reports. Generally, the FCRA applies to consumer credit transactions, but commercial credit transactions involving consumers are also within its scope. Under the FCRA, lenders must have permissible purposes before obtaining credit reports, make certifications to credit organizations on their intended use of credit reports, notify consumers when adverse actions are taken, follow procedure pertaining to identity theft, and resolve discrepancies related to a consumer’s address.
A notable point of confusion for lenders making business purpose loans is when and whose credit can be pulled. As mentioned above, a lender can pull an applicant’s credit report under certain permissible purposes. This includes if an applicant is a natural person. If the borrower or applicant is an entity, the lender has a permissible purpose to pull credit if the principal/officer signing is personally liable for the loan. When the principal is not personally liable, current law does not specify whether it is permissible to pull the principal’s credit.
For this reason, it is important a lender always has the proper authorization from the individual whose credit they are pulling. If there is ever any doubt, lenders should ensure to obtain authorization forms from all relevant parties for business purpose loans.
The Servicemembers Civil Relief Act (SCRA)
The SCRA provides financial protections to servicemembers, and under certain circumstances, individuals related to servicemembers. The Act was created to provide relief to servicemembers on active duty, and only applies when a servicemember borrower has a change in military status (i.e. “off-duty” or “reserve” to “active duty”). Because the SCRA does not distinguish between consumer or commercial credit, business purpose loans are within its scope. However, the servicemember borrower has an affirmative duty to inform a lender of a change in status, in order for the lender to be on the hook for SCRA compliance.
The protections of the SCRA cover various aspects of financial transactions. The notable protections include a six percent cap on interest rates, credit rating protection, judicial relief that can postpone foreclosure, and protections against evictions. Additional protections include the ability to end property and car leases, relief from foreclosure and forced sales, and termination and reinstatement of insurance. Business purpose lenders will find the SCRA most relevant during enforcement proceedings such as modification or foreclosure.
While there is an affirmative duty on the servicemember to advise the lender of the change of status, as a general practice it is recommended that prior to any enforcement proceeding a lender complete a search online to verify that their borrower is not an active servicemember. If they are, the lender can inquire whether that status is new (in which case SCRA protections apply), or if the status is the same from the time of the business purpose loans origination (in which case SCRA protections do not apply).
California Consumer Protection Laws for Business Purpose Loans
In addition to the federal laws discussed above, each state has its own body of laws regulating the lending industry. Private lenders must comply with both federal law and the laws of the state in which they operate. In California, there are relevant lending laws that apply to all business purpose loans, and then a few specific laws relevant to the manner in which the loan is originated.
General California Consumer Protection Laws
In California, business purpose loans can be originated either by lenders holding a California Finance Lender (“CFL”) license or by brokers that arrange the loan that hold a Department of Real Estate (“DRE”) license. Many California laws will apply regardless of how the loan is originated. In particular, many of these California consumer protection laws only apply when the property securing the loan is a 1-4 family property. That being said, there are many other regulations which apply regardless of the type of collateral. This list is not exhaustive, but instead provides an overview of the regulations affecting private lenders making business purpose loans that are often times forgotten.
Owner-Occupied Business Purpose Loans
The first of these regulations which applies to all business purpose loans in California is a limitation on the prepayment penalty that can be charged on owner occupied business purpose loans. California Civil Code provides, “a prepayment charge may be imposed on any amount prepaid in any 12-month period in excess of 20 percent of the original principal amount of the loan which charge shall not exceed an amount equal to the payment of six months’ advance interest on the amount prepaid in excess of 20 percent of the original principal amount.”
In other words, even though it is permissible to make business purpose loans secured by a borrower’s residence, a lender may not enforce a prepayment penalty equal to greater than six months’ advance interest. This is meant to protect homeowners from aggressive prepayment penalties and to allow the ability to easily refinance loans secured by a borrower’s residence.
Per Diem Interest Restrictions
Another restriction that applies when the property securing a loan is a 1-4 family residence is a restriction on when per diem interest can start to accrue. Oftentimes, lenders will send loan proceeds into an escrow a few days before the loan closes and funds to the borrower. For commercial and multifamily properties, the lender could start charging per diem interest as soon as they send proceeds to the escrow company. For business purpose loans secured by 1-4 family residences, the lender may not charge per diem interest until the day before the loan funds to the borrower.
The statute allows for additional per diem interest to be charged in very limited circumstances. In particular, the borrower must have requested the loan fund on a day following a weekend or a holiday, requiring the lender to have funded the escrow several days before. In this case, there is a mandatory document to provide to the borrower that demonstrates the borrower requesting funding on a date certain. Some loan document packages will include this form as a boilerplate document included on every loan transaction. This is not recommended practice, and instead, should only be provided to the borrower for completion if it is relevant in the loan transaction at hand.
The DBO, in particular, has issued various guidance on this issue in the form of educational materials and advisory opinions. This is often the subject of many audits, and when an auditor has determined that a lender has overcharged per diem, they must review all loan files and reimburse their borrowers accordingly. It is recommended that lenders do not make a practice of overcharging per diem, or make sure they only do so when the property securing the loan is commercial or multifamily.
Hazard Insurance Requirements
Most states include a restriction on hazard insurance and California is no exception. Per California Civil Code, “no lender shall require a borrower, as a condition of receiving or maintaining a loan secured by real property, to provide hazard insurance coverage against risks to the improvements on that real property in an amount exceeding the replacement value of the improvements on the property.” In other words, a lender can only require hazard insurance in an amount equal to the replacement costs of the improvements at the property. Sometimes lenders will push back on this, stating that the loan amount is greater than the hazard insurance coverage available.
The purpose of this kind of insurance is to be able to replace any structures at the property in the event of a total or partial loss to the structure. The land and its value will remain, which is oftentimes why the amount of hazard insurance coverage may not fully align with your valuation of the property. A recommendation here would be to determine both the value of the property as a whole as well as the specific value of the structures to confirm you have hazard insurance in the proper amount.
Fair Lending
Similar to the federal Fair Housing Act and the anti-discrimination section of ECOA discussed above, California like many states also has anti-discriminatory legislation in place. Specifically, lenders may not discriminate based on geographic or neighborhood conditions or characteristics or based on an applicant’s race, color, religion, sec, marital status, domestic partnership, national origin, or ancestry.
This applies particularly to loans secured by 1-4 family properties. That being said, if lenders are careful to make sure they comply with federal standards, they will be covered on a state level as well. A similar analysis with regard to ensuring accidental discrimination would apply here as well, as post-audits of loan files and applications will be helpful to make sure a lender’s practices are above board.
California Laws Applicable to Loans Arranged by DRE Licensed Brokers
In addition to the various CA regulations above that apply to all lenders in California, there are several regulations which apply specifically to loans that are brokered by a California DRE licensed broker. Of course, relevant loans disclosures like the MLDS, LPDS, and other investor disclosures will apply on all transactions. In addition to those, the following are several regulations which additionally apply to business purpose loans arranged by a licensed California broker.
Late Charges
A loan arranged by a licensed broker must include a minimum 10 day grace period for payment of monthly installment payments. In addition, when assessing a late charge, the charge is capped at the greater of 10% of the installment owed, or $5.00. Oftentimes, lenders will ask whether they can charge a late charge on a late balloon payment. California prohibits a late charge from being charged on a balloon payment, so while a lender could charge a late charge on any additional installment payment that was due on the maturity date, the lender could not apply that late charge on to the remainder of the principal balance that is due.
The reasoning behind this is that late charges must be “reasonably related” to the harm caused to the lender for having to manage the late charge. This would typically include mailing notices, preparing demand letters, and other means of contacting the borrower to remind them to make their payments, all of which are likely reimbursed by the 10% fee on the installment payment. When a maturity date payment comes due and is missed, the same procedures would apply to managing the late charge, and it does not cost exponentially more. Therefore, the 10% charge does not apply to the principal amount to be repaid at that time.
LTV Limitations
California Business and Professions Code provides various loan-to-value (“LTV”) limitations for loans arranged by licensed brokers. These regulations are in place to protect the lender’s interest, and when a broker decides to exceed such limitations they must thoroughly document the evidence for doing so. CFLs do not have the same restriction as they are the lender and therefore able to competently determine for themselves whether the increased risk is worth it on that particular file.
Construction Loans
Similar to the LTV limitations above, DRE-arranged loans have additional regulations in place for construction loans when the LTV is based on the after-repaired-value of the property AND there is a holdback of loan proceeds.
If the holdback is less than $100,000.00, the following restrictions apply:
- The lender must fully fund the loan and may not net fund any part of the proceeds;
- There must be an actual appraisal done of the property completed by a licensed appraiser, not a BPO or other similar valuation; (iii) the loan documents must include specific instructions for what happens when there is a default under the loan;
- There must be a detailed draw schedule in place for administering the holdback;
- The loan amount may not exceed $2,500,000.00, meaning loans for more than this amount should be split into a loan for the purchase price and another for the construction.
In addition to the previous restrictions, if the holdback is greater than $100,000.00, there are two additional restrictions:
- A third-party funds control must be used to administer the holdback, and
- Licensed parties must inspect the various work completed at the property throughout the disbursal process. Often, the same funds control party can manage the inspections at the property as well.
CFL licensed lenders: Borrower/Broker Statement
California Finance Lenders do not have nearly as many restrictions on their loans as DRE licensed brokers. That being said, CFLs are restricted on the number of brokers they may pay out on a particular transaction. A great way to ensure compliance with this section is to include a “Borrower/Broker Statement” in the loan document package which provides a summary of the loan terms and includes any fees paid to any non-CFL parties.
Conclusion
The legal framework governing business purpose loans is expansive and at times difficult to navigate. While business purpose loans are exempt from two major bodies of federal lending law, a multitude of federal consumer laws still apply. Accordingly, private lenders should adopt procedures that comply with both state and federal requirements. Private lenders with questions about compliance should consult with an attorney versed in federal and state lending laws, who can provide further expertise on these issues.
If you’re seeking expert legal guidance in private lending, our Banking & Finance team is here to assist. The Banking & Finance team specializes in nationwide loan document preparation, lending compliance, and foreclosure and loss mitigation. Contact our team today to get started.
