Title: Chapter 12 The Loan and the Consumer
1Chapter 12The Loan and the Consumer
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2The Truth-In-Lending Act (TILA)
- This chapter deals with the following two topics
- Consumer protections when it comes to borrowing,
esp. as provided in the Truth-In-Lending Act
(TILA), and - The processes of loan application and loan
underwriting. - The Truth-In-Lending Act (actually named the
Federal Consumer Credit Protection Act) was
enacted in 1968, and amended several times since,
with the purpose of requiring lenders to
adequately inform borrowers of the credit
obligations they are taking on when they borrow
money. - The act applies to both consumer loans and
residential mortgage loans. - The main purpose of the act is to provide
sufficient disclosure of the cost of credit so
that borrowers can make informed borrowing
decisions.
3The Truth-In-Lending Act (Cont.)
- The Board of Governors of the Federal Reserve
System was given the authority to set standards
and to implement the Act. - In 1969, the Board issued Regulation Z, which
specifies the rules and the regulatory
requirements of the act. - A Revised Regulation Z was issued in 1982
following enactment of amendments to the TILA in
that year.
4The Truth-In-Lending Act (Cont.)
- The TILA requires certain disclosures (as spelled
out by Reg Z), both in public advertisements and
to borrowers as part of the loan application
process. - The act applies to anyone offering credit terms
to the public, with the following exemptions. - Credit extended for agricultural, business, or
commercial purposes is exempt from the
requirements of the act. - The act applies to mortgage loans for 1-4 unit
residential property. Loans for residential
property in excess of four units are considered
commercial loans. - Credit of more than 25,000 secured by personal
property is also exempt, unless the property is
the principal residence of the borrower, such as
a mobile home.
5The Truth-In-Lending Act (Cont.)
- The five most important disclosures involve the
cost of credit. These five disclosures are - Amount financed the amount of credit provided
- Amount of any required down payment how much is
it, if any - Finance charge the total dollar cost of the
credit, including interest over the loan term,
discount points, loan origination fees, loan
service fees, escrow account charges, mortgage
insurance premiums, and other costs of the loan - Annual percentage rate (APR) the annual cost of
borrowing taking into account the loan interest
rate and all other charges made by the lender for
the loan - Total payments the number of monthly payments,
and the total sum of the payments, or, in the
case of credit sales, the deferred sales price
6The Truth-In-Lending Act (Cont.)
- If an advertisement by anyone advertising as a
supplier of consumer credit includes any one of a
number of trigger terms, then all significant
terms of credit must be included in the ad. - An exception to this rule is the annual
percentage rate, or APR. If the annual
percentage rate appears in the ad by itself, this
does not trigger the requirement of full
disclosure of all loan terms.
7Triggering Items and Disclosures
Triggers disclosure of all five of the following
Mention of any of these
- Cash price or the amount of the loan
- Amount of down payment (or none, if none)
- Number, amount, and frequency of payments
- Annual percentage rate (APR)
- Total payments or deferred payment sales price
- Down payment
- Any payment
- Number of payments
- Period of payments
- Amount of any finance charge, or even a
statement to the effect no charge for credit
8The Truth-In-Lending Act (Cont.)
- The act also requires lenders to make a number of
disclosures to borrowers, in writing, about the
loan. The disclosures must be made before the
transaction is completed (closed). They normally
accompany the loan commitment information sent to
the borrower to examine before loan closing. - In addition to the five major items listed above,
a number of other disclosures, which are listed
in the Jacobus text (p. 204), such as prepayment
penalties, late-payment charges, rebates,
detailed information about the features of
adjustable rate loans, and more, must be made in
a disclosure statement given to borrowers. - The lender must also give the borrower a
statement within 3 days after a loan application
is made showing a complete breakdown of all loan
costs.
9The Truth-In-Lending Act (Cont.)
- For a number of loan transactions, the borrower
must also be informed of a right to rescind
(i.e., cancel) a loan agreement up to 3 business
days (which includes Saturday) after signing the
loan papers. - In other word, a borrower has the right to back
out of a loan agreement about which he or she has
second thoughts. - The right to rescind does not apply to credit
used to acquire a principal residence.
10Annual Percentage Rate (APR)
- The Annual Percentage Rate (APR) is a way of
informing the borrower of the effective cost of
the loan by combining the loan interest rate with
the other loan costs, including discount points,
loan origination fees, mortgage insurance
premiums, and tax service fees, into a single
figure expressed as an annual rate. The
resulting rate approximates the true annual cost
of the loan. - Although expressed as a rate, the APR is not an
interest rate per se. - The APR is a measure of the true, or effective,
cost of a loan taking into account the interest
rate and other loan costs. - The interest rate is the rental charge per period
for the use of money. It is the period cost of
borrowed money.
11Annual Percentage Rate (Cont.)
- Calculation of the Annual Percentage Rate (APR)
assumes that a loan is held for its full term,
i.e., not paid off early. - Thus, whenever loan fees are charged, the APR
will be lower than the true expected borrowing
costs when the loan is paid off early. - In other words, when points and other loan fees
are charged, the effective borrowing increases
with early repayment, but this is not reflected
in the APR. - The Truth in Lending Act requires that the APR be
disclosed to the borrower in a residential
property transaction prior to the loan closing. - The APR is not required to be disclosed to a
commercial or investment property borrower
because these borrowers are assumed to be
sophisticated knowledgeable buyers able to
calculate and understand their own borrowing
costs.
12Process of Obtaining a Real Estate Loan
- Before originating mortgage loans, lenders go
through a process of loan approval. - The process of loan approval refers to the steps
involved in evaluating a loan request (a loan
application) for the purpose of deciding whether
to accept it, reject it, or modify it. - Underwriting the requested loan is an important
aspect of the process of loan approval. - Underwriting is a process of analyzing the
potential default risk of a loan applicant and
the value of the property serving as collateral
for the loan, and determining the appropriate
target yield (effective interest rate) for
assuming the risk. - Default risk is the potential loss to the lender
resulting from a failure of the borrower to make
timely loan payments and from the failure of a
foreclosure sale to cover the loan amount and the
foreclosure costs.
13Process of Obtaining a Real Estate Loan
(Continued)
- The purpose of loan underwriting is to manage
default risk by taking precautions to minimize
the chance of borrower default, and to insure
that, if default occurs, there is sufficient
value in the property serving as collateral to
recover the loan and the foreclosure-related
costs. - The following five phases are involved in
financing real estate with a loan - Loan application
- Borrower and Property Analysis
- Loan processing
- Loan closing
- Loan servicing
14Loan Application
- The lending process begins with the prospective
borrower completing a lenders loan application
form. - Most lenders today use the joint FNMA-FHLMC
standard application form, which is referred to
as FNMA 1003. - The application asks for information about the
borrower his/her financial status, employment
history, etc. - It also asks for information about the property.
- Once the application is complete the lender uses
it as a screening device to determine whether the
borrower and the property meet the lenders
requirements - If it appears that the borrower and the property
are going to be acceptable, then the analysis
phase begins.
15Borrower Analysis
- The analysis phase involves the processes of
qualifying the borrower and qualifying the
property. - Qualifying the borrower entails ensuring that the
borrower has the ability and the character to
make the payments on the mortgage loan. In other
words, the lender wants to analyze the borrowers
capacity to pay and his/her willingness to pay. - Qualifying the borrower is largely based on a
professionally compiled credit report and a
credit score (called a FICO score) for the
applicant. - The three major credit reporting agencies
Equifax, Experian, and TransUnion issue FICO
scores. A FICO score is a single number
summarizing a borrowers credit standing. - Generally, to obtain an A rating, and the best
loan terms, the applicants credit score must be
at least 680 to 700. A credit rating of
approximately 740 is needed for an A. - Extenuating or special circumstances may be taken
into account in addition to the borrowers credit
report.
16Borrower Analysis (Cont.)
- Qualifying the borrower also involves verifying
the information provided on the application.
Employment and income are verified, as are
checking and savings accounts, and other reported
information. - In addition, qualifying the borrower involves
applying payment-to-income ratios. - One ratio is the housing expense ratio. This is
the ratio of monthly housing expense to gross
monthly income. Housing expense is defined as
principal, interest, property taxes, and hazard
insurance premiums. For condos, homeowners dues
and assessments would be included. The currently
accepted ratio value is 28, but in Calif. it is
commonly extended to 30. - A second ratio is total long term debt ratio.
This is the ratio of housing expenses plus
long-term monthly debt payments to gross monthly
income. This ratio value should be between 33
and 38 of gross monthly income. - When all of the borrower analysis is complete,
the lender then makes a determination about the
credit worthiness of the borrower.
17Property Analysis
- There are two aspects to qualifying the property.
- Qualifying the title Involves an examination of
the title for clouds on the title (title defects)
that could interfere with the marketability of
the property. Lenders want marketable property
as security for loans. - To assure the quality of the title, lenders today
generally require the borrower to obtain a
lenders title insurance policy. - Qualifying the collateral value The lender
wants to be sure that there is sufficient value
in the property to cover the loan amount and
foreclosure costs if the property has to be sold
in a foreclosure sale. - This assurance is provided primarily by means of
an appraisal of the property by a staff appraiser
or by an independent fee appraiser. - An appraisal is an estimate of value.
- Real estate appraisers must be state certified.
- In commercial and investment property loans, the
cash flows produced by the property are also
analyzed to assess their ability to meet the
required loan payments.
18Loan Processing, Closing, and Servicing
- Processing involves drawing up the loan papers,
preparing disclosure forms, and issuing
instructions for the escrow agent. - Closing involves signing all of the loan papers,
transferring and recording documents as
appropriate, disbursing funds, and other actions
to finalize the loan transaction. - Servicing involves the record-keeping and payment
collection process once the loan is in force.
Many lenders do their own servicing, while other
lenders pay independent mortgage companies or
loan servicing firms to handle the paperwork of
collecting and processing the loan payments.
19Redlining
- Refusing to make loans in certain areas.
No Loans!
20Subprime Loans
- Borrowers with a risk rating of A (FICO scores
of roughly 680 or higher) are considered prime
borrowers. These get the best loan terms. - Loans to borrowers with a risk rating below A
are referred to a subprime loans. Loans to
subprime borrowers are sometimes referred to as
BC loans. - Subprime loans are more risky than prime loans.
Because the risk of default is higher, subprime
borrowers pay more. - Such loans come with higher interest rates and
higher loan fees. - Subprime borrowers may also face more restrictive
loan terms, such as prepayment penalties and
large down payment requirements. - Subprime borrowers may refinance up into the
prime market (to A Credit) in a few years
providing they keep up a good payment history. - The subprime category has A- to F categories.
21Fair Credit Reporting Act (1992)
- This act was intended to assure that consumer
credit reporting is fair and accurate. It
applies only to credit extended to individual
consumers, not to credit extended for business
purposes. It is administered and enforced by the
Federal Trade Commission (FTC). - If a loan is rejected because of information in a
credit report, this act requires that a borrower
be notified of the name and contact address of
the credit agency. - The borrower then has the right to obtain
information that the credit agency has about the
borrower that led to the rejection, and to
challenge any information that the borrower
thinks is erroneous, or to provide explanatory
comments pertaining to other harmful information.
- If an error is found in the borrowers credit
file, the credit agency must remove or correct
it. - California has a similar act called the
California Consumer Credit Reporting Agencies
Act. This act requires that a credit reporting
agency disclose file information to a consumer
upon request.