The COVID-19 crisis has decimated many small businesses, particularly any business which relies upon consumers gathering in groups such as malls, restaurants, bars, sporting events, and hospitality related industries to name a few.
These businesses are well operated and produce great cash flow in normal markets, and, but for the unprecedented lockdown of our society, would be thriving right now. What these businesses need is short-term liquidity to permit them to survive the next six months until they can resume business as usual. There are many government programs and other stimulus plans to help these small business owners, but many do not have enough time to go through a government loan process. They need money today.
These same business owners are likely to have significant untapped equity in their primary residence. If they are fortunate enough to have a credit line secured by their home, they could pull cash from their home to survive this tumultuous period. Unfortunately, banks are going to be unwilling to provide new financing, given the current environment. Therefore, a great opportunity presents itself for private lenders. They can provide much needed liquidity to a small business in need, and they can do so with adequate collateral.
A common misconception lenders who make business purpose loans have is whether you can make a loan for business purposes that is secured by the personal residence of the borrower. Most people commonly refer to these as “owner occupied,” “conventional,” or “1-4” loans, and call inquiring as to whether they are okay to proceed with the loan. They are often surprised to hear that the type of collateral securing the loan is largely irrelevant to the initial analysis, and that the real consideration is to determine what is the primary purpose of the loan, which is typically determined by understanding what the borrower will be doing with the loan proceeds.
The two major federal bodies of law that govern consumer loan transactions are the Truth In Lending Act (“TILA”) and the Real Estate Settlement Procedures Act (“RESPA”). Both TILA and RESPA impose serious licensing requirements and lending guidelines on lenders that make loans primarily for personal, family, or household (consumer) use, and especially when the loans are secured by the primary residence of the borrower. This makes sense – the government has an interest in protecting everyday people from predatory lending, and from losing their homes due to unfair lending practices.
Fortunately, TILA and RESPA both explicitly exempt loans primarily for a commercial, investment, or agricultural (business) use from their regimes. This means that the most important question lenders need to ask of their potential borrowers before making a loan is: “What are you using the money for?”. As long as lenders have a clearly documented business purpose for the loan proceeds, the collateral securing the loan becomes less important. In addition, the use of the loan proceeds could also be mixed – partially consumer purpose, partially business purpose – but as long as the primary purpose of the loan is for business purposes (at least 51%!), then the loan is exempt from TILA and RESPA.
For owner occupied properties, confirming the business purpose of the loan proceeds is extremely important. In this case, lenders will be prudent to ensure that a strong majority of the proceeds (80%+) is used for a business purpose when dealing with mixed use loans. Getting a handwritten explanation of the intent of loan proceeds from the borrower at time of loan application will be crucial to making the determination as to whether you can make the loan. At time of closing, you will want to include an additional business purpose certificate in your loan document package for the borrower to reaffirm the use of the loan proceeds. And, instead of relying on forms with checkboxes or pre-populated statements, always have the borrowers handwrite in what their business purpose is with as much detail as they can whenever possible to help bolster your exemption from TILA and RESPA.
There are some other considerations to keep in mind when dealing with owner occupied business purpose loans. First, some states will require lenders to be licensed to make these kinds of loans, even if they otherwise would permit lenders that only make business purpose loans to be unlicensed. There are exceptions, of course, but it is recommended to check in with your lending counsel prior to extending an owner occupied business purpose loan to make sure you don’t have a state-specific licensing issue on your hands.
Also, some states will be strict with the interest rate you can charge on owner occupied business purpose loans, so make sure you connect with counsel to make sure your rate is compliant with state law. Finally, there are often times restrictions on late charges and prepayment penalties on owner occupied loans, so, as a general rule, we recommend giving your borrowers at least a ten-day grace period before incurring a late charge (capped at 5%), and not imposing prepayment penalties that are longer than six months.
Owner occupied business purpose loans are completely permissible and common, and can oftentimes help small business owners in times of need. For lenders, these loans are a great opportunity to help a borrower access some of their equity in times of crisis. As long as lenders take the time to verify that the loan is indeed for business purposes, there are few restrictions on making these loans.
