Regulation Z and the Refinance of Business Credit

Issue/Inquiry

The Bank received a request for a commercial mortgage. The collateral property is a five unit multi-family building. The individual requesting the loan lives in one of the units. The purpose of the loan is to refinance an existing loan at another bank and take cash out. Can this loan be booked as a commercial loan or must it be booked as a consumer loan?

Response Summary

The existing loan was probably made for a business purpose. Whether a business credit must be re-written as a consumer credit will depend on (1) whether the credit is a refinancing; and (2) whether it is for a consumer purpose. In this case, the new loan will be a refinancing. Whether the second factor has been satisfied is a question of fact.

Response Detail

Under Regulation Z, if credit is extended to acquire, improve, or maintain rental property that will be owner-occupied, it will be deemed to be for a business purpose if it was used to acquire a property containing more than two housing units, or if it was for the improvement or maintenance of the property containing more than four units. Official Interpretations, §1026.3(a) – 5. In this case, the property consists of five residential units, of which the owner occupies one as his residence. If the existing loan was for the acquisition, improvement, or maintenance of the property, then it would have been deemed to have been a business loan.

Regulation Z exempts business-purpose credit from its requirements. 12 CFR §1026.3(a). However, it also provides that business-purpose credit that is exempt from the regulation may later be rewritten for consumer purposes. Such a transaction is considered consumer credit requiring disclosures only if the existing obligation is satisfied and replaced by a new obligation made for consumer purposes undertaken by the same obligor. Official Interpretations, §1026.3(a) – 6.

A transaction that satisfies or replaces an obligation by the same obligor is a refinancing under Regulation Z. It includes the disbursement of new money, as long as the new obligation completely replaces the prior one. 12 CFR §1026.20(a); Official Interpretations, §1026.20(a) – 1. Given that the existing loan is with another bank, the credit extended by the Bank will necessarily satisfy and extinguish that obligation. Although new money will be advanced, the new loan will be considered a refinancing.

Whether an extension of credit is considered consumer credit depends on its purpose, not the collateral securing it. Regulation Z defines a consumer credit as credit offered primarily for personal, family, or household purposes. 12 CFR §1026.2(a)(12).

The official commentary states that there is no precise test for what constitutes credit offered or extended for personal, family, or household purposes, or what constitutes the primary purpose. It refers to its discussion concerning business purpose, which lists factors to be considered in determining whether credit for an acquisition is primarily for business or commercial purposes. Basically, the greater the ratio of income generated by the acquisition to the total income of the borrower, the larger the transaction, or the closer the relationship of the acquisition to the borrower’s primary occupation, the more likely it is that the credit is being used for a business purpose. The purpose stated by the borrower is also to be considered. Official Interpretations, §1026.2(a)(12) – 1, 3(a) – 3. The rules pertaining to rental properties are discussed above.

The primary purpose of the proposed credit will be a question of fact for the Bank to determine. If most of the proceeds will be used to refinance the balance of the existing business loan and the cash out will be used for a business purpose, such as improvements to or maintenance of the property, the purpose of the loan would be for business. If most of the credit will be to refinance the balance of the existing business loan, but the cash out will be used for a consumer purpose, an argument can still be made that the primary purpose of the credit is for a business purpose, since the business credit being refinanced will not have lost its character.

If a question exists regarding the primary purpose of a creditor extension, the official commentary states that a creditor is free to make Truth-in-Lending disclosures, and the fact that disclosures are made under such circumstances does not determine whether the transaction was exempt. Official Interpretations, §1026.3(a) – 1.

The Bank will have to make a business decision in such a case, given the severe penalties provided by Regulation Z for failing to provide disclosures concerning the loan or closing costs, or to provide the notice of right to cancel.

This entry was posted on Monday, February 6th, 2017 at 1:34 pm.