Real Estate Financing and Investing/Truth-in-Lending Law

The National Consumer Credit Protection Act, referred to as the Truth-in-lending Act, became effective July 1,1969. Regulation Z, published by the Federal Reserve System to implement this law, requires lenders to make meaningful credit disclosures to individual borrowers for certain types of consumer loans. The regulation also applies to all advertising seeking to promote credit. This advertising is required to include specific credit information. Consumers are given information on credit costs both in total dollar amounts and in percentage terms. The intent of Congress was to assist consumers (residential, noninvestment customers) with their credit decisions by providing them with specific required disclosure and does not attempt to establish minimum or maximum interest rates or other charges.

To Whom Does Regulation Z Apply?

Regulation Z applies to a person (or business) who is classified as a "creditor". A creditor is one who regularly extends consumer credit that is either subject to a finance charge or is payable in more than four installments. A person regularly extends consumer credit only if it extended credit more than 25 times (or more than 5 times for transactions secured by a dwelling) in the preceding calendar year. If a person did not meet these numerical standards in the preceding calendar year, the numerical standards shall be applied to the current calendar year. Regulation Z also requires that the note signed by the consumer be payable on its face to the creditor. In other words, Regulation Z applies only to actual extenders, real estate broker or salesperson who helps arrange creative financing to sell a house, the broker salesperson would not have to comply with Regulation Z disclosure requirements.

What Transactions Are Covered?

All real estate lending transactions involving consumers are covered by Regulation Z. Except for real estate transactions, all credit extended in five or more installments and not in excess of $25,000 for personal, family, household or agricultural purposes is covered by the regulation. The regulation does not apply to credit extended to nonnatural persons such as corporations or governments, to credit extended for business and commercial purposes or for credit transactions with an SEC-registered broker for trading in securities and commodities. The regulation applies to new loans, refinancing or consolidation of loans. However, an assumption of a loan by a new borrower is exempt.

Notice that Regulation Z applies to consumer real estate transactions. Would a loan to renovate an apartment building be covered by the regulation? Since an apartment building is normally a business to collect rents from tenants, this would not be deemed a consumer transaction. Thus, the loan would be exempt from Regulation Z reporting requirements.

What Information Must Be Disclosed?

The law requires a lender to make several types of credit information disclosures. Two important disclosures include the finance charge and the annual percentage rate (APR). The finance charge includes a disclosure of the following: interest, finder and origination fees, discount points, service charges, credit report fees and other charges paid by the consumer directly or indirectly which are imposed as an incident to the extension of credit. Certain fees which are not in fact additional finance charges are exempt. These charges may include various title examination fees, escrow requirements and appraisal fees.

To determine the charges which are covered or exempt, Regulation Z should be examined by anyone extending credit to consumers. (Note: this includes brokers, professionals and craftsmen as will as financial intermediaries, unless exempt.) The APR is the yearly cost of credit stated to the nearest one-eighth of 1 percentage point in regular transactions and the nearest one-fourth of 1 percentage point in irregular transactions.

A transaction is irregular if repayment is in uneven amounts or the loan is made in multiple advances. The APR is usually different from the contract or nominal rate of interest and includes the impact on the effective rate from discount points and other charges. The calculation of the APR is complex and involves the use of actuarial tables which are available from the Federal Reserve and member banks.

Example

Tom borrows $1,000 from Holly which is repayable in one payment at the end of the year. The loan is to finance a real estate purchase. They agree to a contract rate of 10% plus four discount points. What is the APR?

Actual Amount Borrowed:
1,000 - $40 (discount points) = $960

Amount to be paid back:
$1,000 + $100 (contract interest) = $1,100

Actual Interest:
$1,100 - $960 = $140
APR:
$140 / $960 = 14.58%

This calculation would differ depending on the term of the loan and the amortization period. If the interest is collected in the beginning, the APR could be twice the contract rate. If the loan involves variable payments, then the creditor must disclose how the payments may change, including the index that is being used, limitations on increases and an example illustrating how payments would change in a given increase.

In addition to the finance charge and the APR, anyone extending credit must also disclose such information as the number, amount and time that the installments are due, description of the penalties and charges for prepayment and the description of the security which is used as collateral, as in refinancing or using a second mortgage to obtain equity. The consumer has three business days to rescind (cancel) the credit transaction. This right of rescission does not apply to credit which was used to purchase the home originally.