Under the Truth in Lending Act, the test for whether a loan will need to comply with consumer loan compliance requirements is based on the purpose of the loan (i.e., what the funds will be used for), not on the type of property used as collateral. The compliance requirements for a consumer loan are different and more onerous than for a business purpose transaction. For instance, on a consumer loan the lender will be required to give the TRID disclosures (including the Loan Estimate and Closing Disclosure), and the penalties for non-compliance with consumer loan regulations tend to be far more severe. Loans where the funds are used for a business purpose are exempt from consumer loan compliance requirements. Thus, inquiring about the purpose of the loan is a vital question to ask before entering into a loan transaction.
Some situations are clearly defined, such as purchasing/refinancing a personal residence (consumer purpose) or financing a commercial transaction (business purpose); however, hard money lenders will often come across scenarios where determining the loan purpose can get complicated. Here are three quick rules of thumb to help figure out which type of loan you are looking at.
The Big Question
The first step for a lender in determining the purpose of a loan is to ask, “What will the money be used for?”. If the money is used for the purchase of a primary residence or is purely refinancing a loan secured by a primary residence, then the loan is consumer purpose. If the money is used to purchase a non-owner-occupied rental property, then the loan is clearly business purpose. The general concept is that if the borrower is using the money for some sort of plan to generate income, then the loan is business purpose, but if the money is only for personal use then the loan is consumer purpose. However, if the money is used to purchase or refinance a multi-unit owner-occupied property or if the loan is a cash-out refinance, there are additional inquiries to make.
Some of the trickiest situations involve 1-4-unit owner-occupied properties. While a loan to purchase an owner-occupied single-family residence is clearly a consumer loan, lenders may feel less certain when faced with an owner-occupied property that has two, three, or even four units. Here, while the borrower is living at the property, there is also an intent to generate rental income from the property.
The rule in this scenario hinges on the number of units. A purchase or refinance of an owner-occupied two-unit property is assumed to be for consumer purpose, but for three or more units it is assumed to be for business purpose.
Follow the Money
A loan purely to refinance a previous loan will be evaluated based on the criteria above, relating to the type of property used as collateral and the original purpose of the loan being refinanced. However, a cash-out refinance where most of the loan is cash-out, or a cash-out loan on an unencumbered property, are different scenarios with different criteria. If a borrower is taking cash out of its primary residence, that loan would be for business purpose if the entire loan amount is used for a business purpose. If a loan is secured by a primary residence and use of the proceeds is being split between business purpose and personal use, the lender should consult an attorney.
Regardless of the circumstances, whenever a lender makes a business purpose loan it is imperative for the lender to document the use of funds and to include a business purpose certification with the loan documents, wherein the borrower writes out how the loan funds will be used. If any issues arise post-closing, these documents will protect the lender by showing that the lender believed it was making a business purpose loan at the time of origination.
Lenders who intend to avoid consumer loan regulations should take care to evaluate the purpose of a loan before entering a transaction to ensure it is business purpose and should then document how the loan funds are being used through the loan documentation.