Chapter 12 The Loan and the Consumer

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Chapter 12 The Loan and the Consumer

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Title: Chapter 12 The Loan and the Consumer


1
Chapter 12The Loan and the Consumer
  • _______________________________________

2
The 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.

3
The 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.

4
The 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.

5
The 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

6
The 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.

7
Triggering 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

8
The 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.

9
The 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.

10
Annual 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.

11
Annual 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.

12
Process 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.

13
Process 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

14
Loan 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.

15
Borrower 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.

16
Borrower 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.

17
Property 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.

18
Loan 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.

19
Redlining
  • Refusing to make loans in certain areas.

No Loans!



20
Subprime 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.

21
Fair 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.
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