Beware of consumer laws that apply to business purpose loans.
Private lenders are often surprised to hear that some consumer laws apply to business purpose loans. Worse yet, some private lenders have been told by their counsel that federal consumer laws do not apply, even though their attorneys claim to be experts in private lending.
What is a Business Purpose Loan?
Business purpose loans are nontraditional mortgage loans that a borrower uses for a nonconsumer purpose (i.e., any loan whose 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.” 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.
Two Major Exemptions
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.”
Because business purpose loans are exempt from TILA and RESPA, when lenders make these loans they do not need to (1) comply with federal requirements to verify the borrower’s ability to repay the loan, (2) issue TRID disclosures or (3) comply with RESPA’s loan servicing requirements. However, various federal consumer laws still apply.
Several consumers laws apply to business purpose loans. Each is discussed below.
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 appraisals, discrimination and 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. The nature of most business purpose lending companies is to evaluate whether to extend credit based on factors such as type of collateral, borrower’s credit score and borrower’s experience relevant to the use of the proceeds. Lenders should ensure that their underwriting guidelines follow those and other similar nondiscriminatory 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 be received by the borrower within 30 days. For borrowers with gross revenue over $1 million the prior year, lenders may notify of adverse actions verbally or in writing within a reasonable timeframe rather than the 30-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 the 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 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 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 loans to developers of residential housing.
Specifically, HMDA applies to lenders who made at least 25 closed-end mortgage loans in each of the last two years, or 100 open-end credit lines in each of the two last years. HMDA requires lenders making the applicable loans to prepare a Loan Activity Register, including certain data to the Consumer Financial Protection Bureau (CFPB). There are over 100 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.
Lenders will need to revise their loan applications to ensure they are capturing the relevant field data in the application process, including 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 that 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.
In 2018, Congress enacted SB 2155 which modified HMDA by easing restrictions on credit unions and other depository institutions. Unfortunately, this legislation does not address private lenders who must still comply with HMDA reporting, even though many of the reporting fields are irrelevant.
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, a lender can pull an applicant’s credit report under certain permissible purposes, including 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 obtain authorization forms from all relevant parties to a loan.
The Service-members Civil Relief Act (SCRA)
The SCRA provides financial protections to service members and, under certain circumstances, individuals related to service members. The act was created to provide relief to service members on active duty. It only applies when a service member 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 service member borrower has an affirmative duty to inform a lender of a change in status 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 6 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. Although there is an affirmative duty on the service member to advise the lender of the change of status, as a general practice, it is recommended that before any enforcement proceeding, a lender complete an online search to verify their borrower is not an active service member. If they are, the lender can inquire whether that status is new (in which case SCRA protections apply) or the same from the time of loan origination (in which case SCRA protections do not apply).
State Consumer Protection Laws
In addition to federal laws, 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 they operate in.
State lending laws typically include a framework for who needs to be licensed and how, what constitutes acceptable charges and interest, the requirements for closing and title, and the procedures after a borrower defaults on a loan. However, it is important to note that the framework may vary state by state. For example, most states exempt lenders originating only business purpose loans from licensing requirements, but 11 states still require licensing of some kind.
Some states have no cap on the amount of interest a lender can charge on a business purpose loan, and others make no distinction between business and consumer purpose loans when addressing this issue. Similarly, state law varies for default procedures, with some states permitting nonjudicial foreclosure and some states requiring a judicial lawsuit. These key differences may lead private lenders to adopt different procedures based on the state in which they are lending.
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. 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.