Insights

After years of controversy concerning mortgage broker compensation practices, Regulation Z was amended in 2011 to impose substantive limitations on compensation. The rule prohibits compensation arrangements that give a mortgage broker or a loan officer incentive to steer a consumer to a loan program based on the amount of compensation the broker or loan officer will be paid rather than the interests of the consumer. The rule contains two parts. The first part of the rule prohibits compensation arrangements that allow compensation to change based on any term of the loan other than the loan amount. The second part of the rule prohibits a broker or loan officer from steering a consumer to a loan that is not in the consumer’s interest because the broker or loan officer will receive more compensation.

Background

The rule applies to any consumer credit transaction secured by a dwelling.[1] As a result, it applies to more than just mortgage loans. A “dwelling” could be real property or personal property under state law. So, for example, a transaction secured by a boat or recreational vehicle could be subject to the rule if the boat or recreational vehicle is a “dwelling” as defined in Regulation Z.[2] Home equity lines of credit subject to § 226.5b (open end lines of credit secured by a consumer’s dwelling) and transactions secured by a consumer’s interest in a timeshare plan as described in 11 U.S.C. 101(53(D)) are not subject to the imitations.[3]

A “loan originator” includes any person who for compensation or other monetary gain, or in expectation of compensation or other monetary gain, arranges, negotiates, or otherwise obtains an extension of consumer credit for another person. Mortgage brokers and their employees are “loan originators.” The rule defines a mortgage broker as any loan originator that is not an employee of the creditor.[4] Employees of a creditor are loan originators. The term also captures a creditor (the original payee on the note or contract) in a table funding transaction – where the creditor does not provide the funds for the transaction at consummation out of the creditor’s own resources, including drawing on a bona fide warehouse line of credit, or out of deposits held by the creditor.[5] The term does not capture loan servicers who negotiate or arrange a modification on an existing loan, unless the modification is considered a “refinancing” under § 226.20(a).[6] The term does not capture administrative and clerical staff who do not arrange, negotiate or obtain a loan for a third party and whose compensation is not based on whether any particular loan is originate.[7]

Compensation Limitations

The rule prohibits compensation based on the terms or conditions of the transaction.[8] It prohibits paying or receiving unlawful compensation. Compensation may be based on the amount of credit extended if the compensation is based on a fixed percentage of the amount of credit extended (including subject to a minimum or maximum dollar amount).[9] The term “compensation” includes salaries, commissions, and any financial or similar incentive provided to a loan originator that is based on any of the terms or conditions of the loan originator’s transactions. Examples of “compensation” include: an annual or other periodic bonus, awards of merchandise, services, trips, or similar prizes.[10] The term also includes processing fees and other charges retained by the loan originator.[11] The term does not include bona fide and reasonable amounts paid to third parties such as title insurance or appraisal fees.

As a general rule, “compensation” includes any mark-up to a third-party charge that is retained by the loan originator. However, if the originator cannot determine with accuracy what the actual charge will be before consummation, the difference retained by the originator is not deemed to be “compensation” if the third-party charge imposed on the consumer was bona fide and reasonable, and also complies with state and other applicable law.[12]

The rule prohibits compensation that varies based on a transaction’s terms and conditions, such as the interest rate, annual percentage rate, loan-to-value ratio, or the existence of a prepayment penalty.[13] The rule also prohibits compensation based on a factor that is a proxy for a transaction’s terms or conditions. For example, if the interest rate on the loan will vary based on a consumer’s credit score or debt to income ratio, those factors are a proxy for the rate, and the loan originator’s compensation may not vary based on those factors.[14] A creditor may not set the originator’s compensation at a certain level and then subsequently lower it in selective cases (such as where the consumer is able to obtain a lower rate from another creditor).

When the creditor offers to extend a loan with specified terms and conditions (such as the rate and points), the amount of the originator’s compensation for that transaction may not increase or decrease based on whether different loan terms are negotiated. For example, if the creditor agrees to lower the rate that was initially offered, the creditor may not reduce the loan originator’s compensation.[15] Compensation may be based on factors such as a loan originator’s overall loan volume, the long-term performance of the originator’s loans, an hourly rate of pay to compensate the originator for the actual number of hours worked, whether the consumer is an existing customer of the creditor or a new customer, a payment that is fixed in advance for every loan the originator arranges for the creditor (e.g., $600 for every loan arranged for the creditor, or $1,000 for the first 1,000 loans arranged and $500 for each additional loan arranged), the percentage of applications submitted by the loan originator to the creditor that result in consummated transactions, the quality of the loan originator’s loan files (e.g., accuracy and completeness of the loan documentation) submitted to the creditor, or legitimate business expenses, such as fixed overhead costs.[16]

The rule allows a creditor to revise the loan originator’s compensation arrangement from time to time. For example, a creditor might periodically adjust the arrangement based on loan performance, transaction volume, or current market conditions.[17]

A creditor may offer the consumer the option to pay closing costs via a higher interest rate. Thus, a creditor may charge a higher interest rate to a consumer who will pay fewer closing costs out of pocket or out of the loan proceeds. A creditor may offer the consumer a lower rate if the consumer pays more of the costs directly. A creditor may offer a consumer different loan terms based on the creditor’s assessment of the credit and other transactional risks involved. A creditor could also offer different consumers varying interest rates that include a constant interest rate premium to recoup the loan originator’s compensation through increased interest paid by the consumer (such as by adding a constant 0.25 percent to the interest rate on each loan).[18]

A loan originator’s compensation may be based on the amount of credit extended. For example, the compensation could be a fixed percentage of the loan amount so long as the percentage does not change with the amount of credit extended. These arrangements could include a minimum and/or maximum dollar amount, as long as the minimum and maximum dollar amounts do not vary with each credit transaction. For example, a creditor could offer a loan originator one percent of the amount of credit extended for all loans the originator arranges for the creditor, but not less than $1,000 or greater than $5,000 for each loan. A creditor could not offer a loan originator one percent of the amount of credit extended for loans of $300,000 or more, two percent of the amount of credit extended for loans between $200,000 and $300,000, and three percent of the amount of credit extended for loans of $200,000 or less.[19]

If a consumer pays the loan originator, no other person may pay any compensation to the loan originator, directly or indirectly, in connection with that transaction.[20] Payments made out of loan proceeds are considered paid by the consumer. Payments made to the loan originator for bona fide and reasonable third-party charges, such as title insurance or appraisals are not considered payments to a loan originator for purposes of this limitation, whether the payment comes from the consumer or the creditor. Payments made by the creditor out of an increased interest rate are considered paid by the creditor and not compensation received directly from the consumer.[21] The restrictions relate only to payments, such as commissions, that are specific to, and paid solely in connection with, the transaction.

A mortgage broker or a creditor may pay a salary or hourly wage to its employee, even if the consumer pays a fee to the loan originator in connection with a specific credit transaction.[22] Affiliates are treated as a single person under the rule.[23] So, the transaction-specific compensation paid to a loan originator must be the same regardless of which affiliate ends up making the loan.[24]

Steering Prohibited

A loan originator may not direct or “steer” a consumer to a transaction because the transaction will maximize the amount of creditor-paid compensation, unless the transaction is in the consumer’s interest.[25] “Steering” means advising, counseling, or otherwise influencing a consumer to accept a transaction.[26]

In determining whether a transaction is in the consumer’s interest, a loan originator must compare the transaction to other possible offers available from creditors with whom the loan originator does regular business and for which the consumer is likely to qualify. A loan originator may identify possible loan offers based on the creditor’s current credit standards and its current rate sheets or other similar means of communicating its current credit terms to the loan originator. An originator need not inform the consumer about a potential transaction if the originator makes a good faith determination that the consumer is not likely to qualify for it.[27]

The rule does not require a loan originator to direct a consumer to the transaction that will result in the least amount of creditor-paid compensation (although, that would meet the rule’s requirements). A loan originator may direct the consumer to a transaction that will result in more creditor-paid compensation, so long as the terms and conditions of the transaction are the same or better for the consumer when compared to a transaction that would result in less creditor-paid compensation.[28]

Anti-Steering Safe Harbor

The anti-steering rule includes a safe harbor.[29] In order to qualify for the safe harbor, a loan originator must present the consumer with options for each type of transaction in which the consumer expressed an interest. The rule breaks “types of transactions” down into three general categories: loans where the rate could increase, loans where the rate cannot increase, and reverse mortgages.

A loan originator must present each of the following options for each category: (i) the loan with the lowest interest rate; (ii) the lowest rate loan that does not have negative amortization, a prepayment penalty, interest-only payments, a balloon payment in the first 7 years of the life of the loan, a demand feature, shared equity, or shared appreciation; or, in the case of a reverse mortgage, a loan without a prepayment penalty, or shared equity or shared appreciation; and (iii) the loan with the lowest total dollar amount for origination points or fees and discount points.

The loan originator must obtain loan options from a significant number of creditors with whom the originator regularly does business.[30] “Significant” means three or more. If the loan originator regularly does business with fewer than three creditors, the loan originator must obtain loan options from all the creditors.[31] A loan originator may satisfy the safe harbor by presenting loan options from only one creditor if that creditor’s loans offer the best terms for each type of transaction.[32]

A loan originator regularly does business with a creditor if there is a written agreement between the originator and the creditor governing the originator’s submission of mortgage loan applications to the creditor and (i) the creditor has extended credit secured by a dwelling to one or more consumers during the current or previous calendar month based on an application submitted by the loan originator or (ii) the creditor has extended credit secured by a dwelling twenty-five or more times during the previous 12 calendar months based on applications submitted by the loan originator. The previous 12 calendar months period begins the month before the month in which the loan originator accepts the consumer’s application.[33]

To identify the loan with the lowest interest rate, the loan originator must use the initial rate that would be in effect at consummation if the rate on the loan will be fixed for at least five years, the fully-indexed rate if the rate will vary during the first five years based on changes to an index, and the highest rate that would apply during the first five years if the loan has a stepped-rate.[34]

The belief that the consumer is likely to qualify must be based on information reasonably available to the loan originator at the time the loan options are presented to the consumer. The loan originator may rely on information provided by the consumer, even if it subsequently is determined to be inaccurate. A loan originator is not expected to know all aspects of each creditor’s underwriting criteria. But pricing or other information that is routinely communicated by creditors to loan originators (such as rate sheets showing creditors’ current pricing and the required minimum credit score or other eligibility criteria) is considered to be reasonably available to the loan originator.[35]

Record Retention

Regulation Z requires a creditor to maintain records evidencing compliance with the loan originator compensation rules for two years.[36] The records must include the compensation paid to the loan originator on the transaction and the compensation agreement that was in effect when the rate was set on the loan.

Timothy P. Meredith is a partner in the Maryland office of Hudson Cook, LLP. Tim can be reached at 410-865-5404 or by email at tmeredith@hudco.com.

[1]Regulation Z § 226.36(d). The rule was published in the Federal Register on September 24, 2010. 75 FR 58509 (September 24, 2010). Compliance with the rule becomes mandatory on April 1, 2011. The rule applies if a creditor receives an application on or after April 1, 2011. See, 75 FR 58509, at p. 58530. In issuing the final rule, the Board relied on its authority in TILA Sections 129(l)(2)(A) and (B) to prohibit acts or practices relating to mortgage loans that are unfair and to refinancings of mortgage loans that are abusive and not in the interest of the borrower. See, 75 FR 58509, at p. 58509.

[2] See, Regulation Z § 226.2(a)(19).

[3] Regulation Z § 226.36(f).

[4] Regulation Z § 226.36(a)(2).

[5] Regulation Z § 226.36(a)(1).

[6] Commentary ¶ 226.36(a)-1-iii.

[7] Commentary ¶ 226.36(a)-4.

[8] Regulation Z § 226.36(d)(1)(i).

[9] Regulation Z § 226.36(d)(1)-ii.

[10] Commentary ¶ 226.36(d)(1)-1-i.

[11] Commentary ¶ 226.36(d)(1)-1-ii.

[12] Commentary ¶ 226.36(d)(1)-1-iii.

[13] Commentary ¶ 226.36(d)(1)-2.

[14] Commentary ¶ 226.36(d)(1)-2.

[15] Commentary ¶ 226.36(d)(1)-5.

[16] Commentary ¶ 226.36(d)(1)-3.

[17] Commentary ¶ 226.36(d)(1)-6.

[18] Commentary ¶ 226.36(d)(1)-4.

[19] Commentary ¶ 226.36(d)(1)-9.

[20] Regulation Z § 226.36(d)(2).

[21] Commentary ¶ 226.36(d)(1)-7.

[22] Commentary ¶ 226.36(d)(2)-1.

[23] Regulation Z § 226.36(d)(3).

[24] Commentary ¶ 226.36(d)(3)-1. The term “affiliate” is defined at Regulation Z § 226.32(b)(2).

[25] Regulation Z § 226.36(e)(1).

[26] Commentary ¶ 226.36(e)(1)-1.

[27] Commentary 226.36(e)(1)-2-i.

[28] Commentary ¶ 226.36(e)(1)-2-ii.

[29] Regulation Z § 226.36(e)(2).

[30] Regulation Z 226.36(e)(3).

[31] Commentary ¶ 226.36(e)(3)-1.

[32] Commentary ¶ 226.36(e)(3)-1.

[33] Commentary ¶ 226.36(e)(3)-2.

[34] Commentary ¶ 226.36(e)(3)-3.

[35] Commentary ¶ 226.36(e)(3)-4.

[36] Commentary ¶ 226.25(a)-5.