Extension of Mortgage Loan When Use of Property Changes

Issue/Inquiry

The Bank has a residential mortgage loan secured by a live-in/work space condominium unit that was the borrower’s primary residence and office at the time of origination. The purposes of the loan were to refinance an existing loan on the condo unit that was used to pay for renovation expenses for the conversion of the unit, which was purely commercial, into a live-in/work space and provide business working capital.  The loan is maturing and the borrower has requested an extension of the term. The borrower has stated in writing that the condo unit is now used primarily for business, and the borrower currently resides in another apartment. Therefore, the Bank would like to convert this residential mortgage loan into a commercial mortgage loan.  Is there any residential mortgage loan regulation that would prohibit it from making this conversion?

Response Summary

The loan could be extended, whether it is considered to have a consumer or business purpose, without the necessity of providing new Truth-in-Lending Act (“TILA”) disclosures. In addition, if it is deemed to be for a business purpose, a refinancing of the loan is exempt from Regulation Z disclosure requirements. In such case, the loan could be categorized as a commercial mortgage loan.

Response Detail

Modification or Refinancing:

Under Regulation Z, the refinancing of a consumer loan triggers new TILA disclosures, but a modification does not. This means that, whether the loan has a consumer or a commercial purpose, the Bank will not have to provide new TILA disclosures if the loan is simply modified.

A “refinancing” is a new transaction requiring new disclosures to the consumer. It occurs when an existing obligation is satisfied and replaced by a new obligation undertaken by the same consumer, based on the parties’ contract and applicable law. In any form, the new obligation must completely replace the prior one. 12 CFR 1026.20(a); Official Interpretations, 20(a)-1.

The following types of transactions will not be treated as a refinancing:

• A renewal of a single payment obligation with no change in the original terms
• A reduction in the annual percentage rate with a corresponding change in the payment schedule
• An agreement involving a court proceeding
• A change in the payment schedule or a change in collateral requirements as a result of the consumer’s default or delinquency, unless the rate is increased or the new amount financed exceeds the unpaid balance plus earned finance charge and premiums for the continuation of insurance
• The renewal of optional insurance purchased by the consumer and added to an existing transaction, if disclosures relating to the initial purchase were provided as required. 12 CFR 1026.20(a).

Under these circumstances, the Bank could take a new promissory note without having to provide the TILA disclosures that would be required for a refinancing. However, if the creditor increases the rate based on a variable-rate feature that was not previously disclosed or adds a variable rate feature to the obligation, new TILA disclosures must be provided, even if the modification is not accomplished by the cancellation of the old obligation and substitution of a new one. Official Interpretations, 1026.20(a)-3.ii.A.

In order to avoid the requirement of providing new TILA disclosures, the documentation by the Bank regarding the new terms of repayment should avoid any implication that the modification or extension is a refinancing. To that end, the Bank should ensure the following:

• The credit request and underwriting documentation must substantiate that the intention of the Bank and the borrower is to modify the existing obligation, rather than replace it.
• The loan cannot be satisfied, cancelled, or replaced.
• The promissory note evidencing the loan must remain in effect.
• The modification agreement should refer to the existing loan(s) evidenced by the notes, indicate that the modification is not a novation (i.e., an obligation that has been given in substitution of another obligation), and provide for the modification of the terms of the notes.

Business Purpose:

If the purpose of the transaction is commercial in nature, new TILA disclosures will not have to be provided, even if it is a refinancing. 12 CFR 1026.3(a)(2).

Although Regulation Z does not define what a “business loan” is, the official commentary with respect to acquisitions offers several factors to be considered when determining whether a loan is primarily for a business or commercial purpose:

• The relationship of the borrower’s primary occupation to the acquisition, in that the more closely related they are, the more likely it is a business purpose
• The degree to which the borrower will manage the acquisition, in that the more personal the involvement, the more likely it is to be a business purpose
• The ratio of income from the acquisition to the total income from the borrower, in that the higher the ratio, the more likely it is to be for a business purpose
• The size of the loan, in that the bigger the loan, the more likely it will be for a business purpose
• The borrower’s statement of purpose for the loan. Official Interpretations, 3(a)-3.

The same factors are also relevant when determining the purpose of any other loan. In this case, the borrower’s statement indicates that the condominium unit is being used as his business office and is no longer considered his residence. This indicates a strong relationship of the loan to the borrower’s primary occupation, and, therefore, the refinancing has a business purpose. As such, the refinancing could be categorized as a commercial mortgage loan that is exempt from Regulation Z disclosure requirements.

In determining the purpose of a refinancing, the Bank should include the borrower’s statement and any corroborative information it can develop regarding the statement. An example of such information would be the address of the apartment that the borrower is residing in, which would be different than the address of the condominium unit securing the loan. The statement would be stronger if the borrower said that the condominium unit is only being used as a business office and the residential space is not being leased to anyone else.

This response is for informational purposes only and is not intended for legal guidance.

This entry was posted on Monday, May 4th, 2020 at 9:23 am.