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Will State Restrictions on Interest Compounding HAMPer Loan Modifications?
By Meghan Musselman

In February 2009, the Obama Administration announced the Making Home Affordable initiative, a sweeping plan to encourage recovery in the housing market and to prevent foreclosures. The centerpiece of this effort is the Home Affordable Modification Program (“HAMP”). HAMP provides financial incentives to mortgage servicers to modify qualifying mortgage loans by reducing monthly payments to amounts borrowers can afford, thus increasing the likelihood that more homeowners will remain in their homes.

Under the Treasury Department’s HAMP guidelines, servicers may capitalize accrued interest and other past due amounts and add those amounts to the principal balance of the loan unless state law prohibits such capitalization. Those capitalized amounts will earn interest going forward. As such, any unearned interest included in the principal balance is compounded, and the servicer earns interest upon interest. However, HAMP does not preempt state law. Therefore, because some states restrict or prohibit interest compounding, servicers participating in HAMP must determine as a threshold question whether states restrict interest compounding as contemplated by HAMP.

The traditional concept of interest compounding is an agreement in advance to compound future interest not currently due and owing. For example, the parties agree in the loan contract to automatically add any unpaid interest during the term of the loan to principal and that interest will accrue on that amount going forward. However, interest compounding under HAMP and many other modification programs involves an agreement to charge interest on interest after that interest has become due and owing.

States address interest compounding in various ways. Many states do not restrict interest compounding and thus pose no restrictions for servicers engaged in HAMP modifications. Some states limit agreements to compound future interest not currently due and owing, but expressly permit the type of compounding contemplated under HAMP; that is, state law allows an agreement to add accrued interest to principal and charge interest on that interest provided that the parties enter into the agreement after the interest has become due and owing. For example, Minnesota’s usury law limits traditional interest compounding, but expressly permits an agreement to charge interest upon interest after that interest has become due and owing. The laws of these states pose no issue under HAMP, as such laws clearly permit servicers to capitalize past due interest.

However, other states do not specifically address this question and present somewhat of a gray area for servicers participating in HAMP. Some state statutes appear to limit traditional compounding, but do not address the type of compounding contemplated under HAMP. For instance, Arkansas’ usury law limits interest compounding, but the statutory language appears to contemplate only traditional interest compounding. Arguably, the state did not intend to restrict the type of interest compounding contemplated under HAMP. Arkansas case law supports this view and suggests that courts will permit an agreement to charge interest on interest after that interest has become due and owing. Other states, like Oklahoma, do not address interest compounding by statute. However, case law in Oklahoma also suggests that courts would allow an agreement to compound interest after that interest is due and owing.

In states where the law does not expressly address whether it permits the type of compounding contemplated under HAMP, there is little risk for servicers modifying first-lien closed-end mortgages. Further, it seems unlikely that state courts or a state regulator would interpret state law as prohibiting servicers from modifying loans in accordance with a federally supported plan to help homeowners avoid foreclosure. Servicers can take comfort that the issue of interest compounding should not hamper their modification plans.

Meghan Musselman is an associate in the Maryland office of Hudson Cook, LLP. Basis Points readers can reach Meghan at 410-865-5403 or by email at mmusselman@hudco.com.

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