Modification or refinancing?
By Bolduc, Josh | |
Proquest LLC |
Most bankers and loan originators are familiar with the concept of loan modifications as an alternative to a refinancing. A modification can be a useful tool for accommodating borrowers facing difficult circumstances or simply maintaining an existing credit.
This remains a desirable alternative to refinancing because it permits both borrower and bank to agree on new terms, effectuating a streamlined process while avoiding the costly disclosure and closing requirements for borrowers and banks alike.
Despite the widespread use and continuing viability of this option, however, loan modifications represent a source of confusion in the industry. Unfortunately, Dodd-Frank and recent regulatory developments have further clouded this issue, and while most are familiar with the theoretical practice of a loan modification, the practical application of this concept is an entirely different matter.
At first glance, the distinction between a modification and refinancing appears simple: a refinancing occurs when the original obligation is replaced and satisfied by a new obligation. The commentary to Reg Z emphatically confirms this key principle of a refinancing: "in any form, the new obligation must completely replace the prior one."
Exceptions to the rule
The regulation then provides several exceptions to that general rule. The following will not be considered a refinancing even when the existing obligation is cancelled and replaced by a new obligation:
* A renewal of the obligation with no change in terms
* A reduction in the APR with a corresponding change in payment
* A change in the payment schedule or collateral requirements resulting from the borrower's default or delinquency
* A change resulting from the borrower's renewal of optional insurance
* A change resulting from an agreement in court proceeding
Notwithstanding the exception for courtordered agreements, the other exceptions share a common theme in that the borrower is not adversely affected by changes to the obligation. The logical inference is that regulators are willing to exempt from disclosure requirements those transactions where changes are made to benefit the borrower.
Considering the underlying purpose of Truth in Lending, it makes perfect sense to exclude these types of transactions from coverage. The introductory text of Regulation Z provides that the purpose of the act is "to promote the informed use of consumer credit by requiring disclosures about its terms and cost."
But where there are no additional costs associated with a transaction and no other changes detrimental to the consumer, there should be no need for additional disclosures. Consequently, loan originators should feel free to modify existing obligations to the benefit of the consumer without fear of implicating Reg Z or violating its provisions.
Of course, this is the easy part. Examiners should have no concern on a transaction that strictly benefits the borrower because there are no costs to compare and the purpose of TIL is not offended.
Conflicting regulatory messages
This real issue, and the cause of so much angst throughout the industry, stems from conflicting messages found in the regulation and its commentary. On one hand, we know that a refinancing occurs only when the existing obligation is satisfied and replaced by a new obligation. On the other hand, we know that certain consumer-friendly changes do not constitute refinancings even when the obligation is replaced and satisfied.
Read together, these two principles imply that there must be a middle ground somewhere where the obligation is both replaced and satisfied, changes in terms are not purely for the benefit of the borrower, and the end result is a modification exempt from TIL requirements.
Unfortunately, the
"A mortgage loan modification is a change in your loan terms. The modification should be designed to reduce your monthly payment to an amount you can afford."
While this statement does not exactly constitute an authoritative statement of law, it would be a mistake to discount its significance. It is tempting to adopt a hardline stance and assume that the regulation is the final authority and anything else is ineffectual or a mere suggestion.
But this would be a dangerous position to take, and it is ill advised. The
What is a loan modification?
So now we come to the million dollar question: what is a loan modification and exactly how far can the original terms of the obligation be altered without triggering redisclosure requirements? The unfortunate answer is that we just don't know.
A strict reading of the regulations would suggest that banks have unlimited discretion to change the terms of the existing obligation provided the original note is not replaced and satisfied. But this interpretation simply must be too good to be true.
It is difficult to imagine a scenario where a bank provides no new disclosures and "modifies" a loan to an extent where the original obligation becomes unrecognizable, meanwhile examiners and the
On the opposite end of the spectrum, the
Unfortunately, the middle ground here is vast, and we have very little authority from which we can adopt a more reasonable interpretation. Other than the provisions discussed above, the regulations are largely silent on where the line is drawn between a mere modification and a refinancing requiring new disclosures.
What do the courts say?
This issue remains undecided in court as well. Since the adoption of the Truth in Lending Act, several cases have discussed the matter of refinancings and modifications, but only in the context of the official definition; i.e., replacing and satisfying the original obligation.
In the absence of a more definitive regulatory provision and any binding legal precedent, we are left to draw our own conclusions. The issue, however, is too complex to attempt a single interpretation or rule on what changes may cross into the threshold of a refinancing. Instead, the determination between a refinancing and a modification will depend heavily on the facts of the individual transaction.
Those changes that are inherently consumer-friendly, or at the very least not adverse to the consumer, are unlikely to constitute a refinancing. For example, changes such as decreasing the rate or simply extending the maturity to a later date are too small to warrant new disclosures.
Conversely, other changes are inherently more impactful and may require additional disclosures so the borrower can make an informed choice pursuant to the purpose of the regulation. Substantially increasing the rate, extending new money or requiring additional collateral should give you pause because they represent substantial changes to the obligation.
For those types of changes, additional disclosures may be necessary to fully inform the borrower of their effect. It may also be prudent to consider whether the new agreement depends on a new credit decision. If the bank is unwilling to enter into a new agreement without reestablishing the creditworthiness of the borrower, chances are the changes are substantial enough to warrant new disclosures.
Document and tread carefully
In short, this determination may be very subjective. As is the case whenever a matter is left to the bank's discretion, you will need a reasonable basis for your determination. Document these reasons and ensure the facts at hand support your decision to treat it as a modification. Of course, if the matter is too close to decide, you may always provide new disclosures - to use everyone's favorite default rule - as "an abundance of caution."
The purpose of this article is not to recommend that banks forego their policies of modifications in lieu of refinancings. This remains a viable option for banks and borrowers seeking to change the terms of an obligation at little or no cost.
Instead, consider this an advisement to tread carefully when making changes to an existing obligation. The line between a modification and refinancing is almost certainly not as simple as asking whether the original obligation has been replaced and satisfied.
This is a determination that may be heavily dependent on the facts and the actual consequences of the new agreement to the borrower. So rather than rely on a simplified, albeit confusing, regulatory definition, consider the scope of the agreement against the purpose of the Truth in Lending Act and the real consequences to the borrower.
"Consider this an advisement to tread carefully when making changes to an existing obligation. The line between a modification and refinancing is almost certainly not as simple as asking whether the original obligation has been replaced and satisfied. "
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Copyright: | (c) 2014 Texas Banker Association |
Wordcount: | 1490 |
Erie Times-News, Pa., Kevin Cuneo column
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