Insights

The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act might give Congress and federal regulators an opportunity to reexamine two consumer credit myths:

Myth #1. The Rule of 78’s is always unfair.

15 USC Section 1615 generally prohibits using the Rule of 78’s method of calculating unearned interest in a precomputed consumer credit transaction if the term exceeds 61 months. Many state laws also restrict use of the Rule of 78’s, presumably because it is “front end” loaded with respect to interest earnings. (In the first one-third of the term of a fully amortizing consumer credit transaction, the Rule of 78’s method considers approximately one-half of the total precomputed interest to have been fully earned.)

Interestingly, however, some well-respected consumer finance authorities have argued that the Rule of 78’s is actually an equitable way to calculate unearned interest, because it recognizes that the consumer retains much greater use of loan proceeds during the first half of the loan term than for the second half of the loan term. A fully amortizing payment schedule does not pay down principal evenly - less principal is repaid in the first half of the scheduled loan term than the second half, based on conventional amortization tables. This disparity is further increased if one factors the time value (present value) of money into the equation.

In 1972, Griffith L. Garwood, at that time chief of the Federal Reserve Board’s Truth in Lending section, wrote that the Rule of 78’s is “fairly equitable,” and “allows for the fact that during the early life of the loan, the customer has use of a greater proportion of the proceeds that he does later.” Presently, on the Federal Reserve Bank of San Francisco web site, that Federal Reserve Bank states that “for loans of less than five years and with interest lower than 15 percent, the payoff calculated by the Rule of 78 is similar to that calculated with the actuarial method….” For loans with significantly longer terms, however (such as mortgage loans), one should consider the likelihood that the loans will not reach their scheduled maturity and will instead be paid off early (whether due to a refinancing or the sale or transfer of the underlying collateral) – in other words, many consumers choose to prepay and thereby add a “balloon” payment feature to longer-term amortizing installment loan obligations. The State of Illinois Division of Banking web site also notes that differences between earned and unearned interest under the Rule of 78’s and actuarial methods are greatest during the first one-third of the loan term, and then decrease.

Myth #2. Mortgage loan escrow accounts are always good.

The Federal Reserve Board has imposed a mortgage escrow requirement for property taxes and insurance on most “higher-priced” first mortgage loans. (See 12 CFR Section 226.35(b)(3).) The consumer generally may not be allowed to cancel the escrow requirement during the first year of a higher-priced mortgage loan. Presumably this is to help the consumer better budget the costs of property taxes and homeowner’s insurance premiums, and to help reduce the chance a borrower might obtain a mortgage loan that has manageable required loan payments but no required escrow payments, and who may be unable to set aside enough funds post-closing to cover the next property tax or property insurance bill, creating a likely default within the first year of the mortgage loan.

The Dodd-Frank Act limits this mortgage escrow requirement to higher priced first mortgage loans with principal amounts that do not exceed Freddie Mac’s conforming loan limit (generally $417,000). For loans with principal amounts greater than Freddie Mac’s conforming loan limit (so-called “jumbo” first mortgage loans) an escrow account is required under the Dodd-Frank Act if the Annual Percentage Rate on the “jumbo” loan is one percentage point (one hundred basis points) or more higher than the rate threshold for a “higher-priced” first mortgage loan. This higher rate threshold for “jumbo” first mortgage loans might be because rates are typically higher for “jumbo” loans than for conforming loans, all other things being equal, and might also reflect the general perception that borrowers eligible to receive “jumbo” loans might not require as much forced budgeting for property taxes and insurance as borrowers who receive conforming loans.

It’s also possible, however, that Congress isn’t convinced escrow accounts are always pro-consumer, because the Dodd-Frank Act requires the Department of Housing and Urban Development (HUD) to “examine the role of escrow accounts in helping prime and nonprime borrowers to avoid defaults and foreclosures,” submit a preliminary report to Congress on this issue in 12 months, and submit a final report to Congress on this issue in 24 months.

In Connecticut, which generally requires residential mortgage loan escrow accounts to pay interest at no less than 1.50% per year to the mortgagor, some borrowers might specifically request a mortgage loan escrow account in cases where the lender or servicer would not require an escrow, since 1.50% per year is a fairly attractive interest rate right now from a consumer’s standpoint.

On the other hand, recent press reports suggest that borrowers with mortgage loan escrows for property taxes (who therefore do not receive property tax bills) may not be aware of certain property tax reductions, exemptions, and deferments that might apply to them (because notice of those reduction, exemption, and deferment options is often included with the property tax bill, which would typically be sent directly to the mortgage loan servicer if property taxes are the subject of an escrow requirement). So the pro’s and con’s of mortgage loan escrow accounts may not be the same for all mortgage borrowers, just as the pro’s and con’s of the Rule of 78’s also may not be the same for all borrowers.

Elizabeth C. Yen is a partner in the Connecticut office of Hudson Cook, LLP. Elizabeth can be reached at 203-776-1911 or by email at eyen@hudco.com.