High-Cost Mortgage

A high-cost mortgage is a consumer credit transaction secured by the consumer's principal dwelling that meets one or more of the coverage tests in 12 CFR 1026.32(a)(1): an annual percentage rate more than a set number of percentage points above the average prime offer rate for a comparable transaction, total points and fees above a set share of the loan amount, or a prepayment penalty the creditor may charge more than 36 months after closing or that can exceed 2 percent of the amount prepaid. The rules come from the Home Ownership and Equity Protection Act, and the name has changed with the statute. The Consumer Financial Protection Bureau records the older usage plainly: these transactions "have been referred to as 'HOEPA loans' or 'Section 32 loans'", and the Bureau now uses "high-cost mortgages" to match the Dodd-Frank Act's own wording. "Section 32" points at the section of Regulation Z that carries the rules, today 12 CFR 1026.32, which is why the older name survives in the trade.

Three doors into the category, and only one has to open. Paragraph 1026.32(a)(1) is written in the disjunctive, so a loan becomes a high-cost mortgage the moment any single test is met, whatever the other two say. The rate test at (a)(1)(i) compares the loan's annual percentage rate with the average prime offer rate for a comparable transaction and is crossed at more than 6.5 percentage points for a first lien, more than 8.5 points for a subordinate lien, and more than 8.5 points for a first lien where the dwelling is personal property and the loan amount is under $50,000. The points and fees test at (a)(1)(ii) is crossed at more than 5 percent of the total loan amount on a loan at or above a threshold loan amount, and on a loan below that threshold at the lesser of 8 percent of the total loan amount or a dollar cap. The prepayment test at (a)(1)(iii) is crossed where the contract lets the creditor charge a prepayment penalty more than 36 months after consummation or account opening, or penalties that together can exceed 2 percent of the amount prepaid.

Two of those dollar figures move and one does not, and the difference is written into the regulation itself. Both the threshold loan amount and the dollar cap in the fee test "shall be adjusted annually on January 1 by the annual percentage change in the Consumer Price Index that was reported on the preceding June 1", so neither is printed here: the amounts that apply in any given year come from the Bureau's official commentary to 1026.32, and a figure read off the codified text is out of date by the following January. The $50,000 in the rate test carries no such instruction and stands as codified. The 6.5, 8.5, 5, 8 and 2 percent figures are fixed in the text and do not move at all.

What counts as points and fees is its own question. The test uses the definition at 1026.32(b)(1), which starts from the finance charge and then subtracts interest, agency mortgage-insurance premiums, certain other guaranty premiums, bona fide third-party charges the creditor and its affiliates do not keep, and up to two bona fide discount points where the undiscounted rate is within one percentage point of the average prime offer rate (or one point where the undiscounted rate is within two points). It then adds loan-originator compensation attributable to the transaction and several other items. Two loans with identical closing costs can therefore land on opposite sides of the threshold depending on who kept which fee.

Four transactions are outside the rules entirely. Under (a)(2) the section does not apply to a reverse mortgage subject to 1026.33, a loan financing the initial construction of a dwelling, a transaction originated by a Housing Finance Agency acting as the creditor, or a loan originated under the Department of Agriculture's Rural Development Section 502 Direct Loan Program. Everything else secured by a principal dwelling is tested, including a home equity line of credit, which is why several of the rules below have an open-end version.

Coverage forbids terms, and the list is specific. Paragraph 1026.32(d) says a high-cost mortgage "shall not include" a payment schedule with a payment more than twice a regular periodic payment, a payment schedule whose regular payments cause the principal balance to increase, a schedule that "consolidates more than two periodic payments and pays them in advance from the proceeds", an interest rate increase after default, an interest rebate computed by a method less favorable than the actuarial method, or a prepayment penalty. The balloon prohibition carries three exceptions for closed-end credit and a separate carve-out for open-end plans: (d)(1)(ii) excepts a schedule adjusted to the consumer's seasonal or irregular income, a bridge loan of twelve months or less connected with acquiring or constructing the consumer's principal dwelling, and a loan meeting the small-creditor conditions Regulation Z sets elsewhere; (d)(1)(iii) separately excepts the payment change an open-end plan makes when it moves from its draw period into its repayment period. A demand feature is also barred by (d)(8), except for fraud or material misrepresentation, payment default, or conduct that harms the creditor's security.

And coverage imposes duties, which is the half most summaries skip. Section 1026.32(c) requires a conspicuous disclosure carrying the statement that the borrower is "not required to complete this agreement merely because you have received these disclosures or have signed a loan application", along with the annual percentage rate, the regular payment and any permitted balloon payment, the maximum payment on a variable-rate loan, and the amount borrowed. Section 1026.34 then adds conduct rules. A creditor may not extend a high-cost mortgage without a written certification that the borrower received counseling on the advisability of the loan from a counselor approved by HUD or a state housing finance authority, that counseling must come after the borrower has the cost disclosures, the counselor may not be employed by or affiliated with the creditor, and the creditor may not steer the borrower to a particular counselor. A creditor "may not finance charges that are required to be included in the calculation of points and fees". Within one year of making a high-cost mortgage, a creditor may not refinance it into another high-cost mortgage for the same borrower unless the refinancing is in that borrower's interest. No fee may be charged to modify, renew, extend or amend the loan or to defer a payment. Payoff statements are free, with narrow exceptions for delivery by fax or courier and for more than four requests in a calendar year. A creditor selling the loan must hand the buyer a notice warning that "Purchasers or assignees of this mortgage could be liable for all claims and defenses with respect to the mortgage that the consumer could assert against the creditor." And 1026.34(b) forbids structuring a transaction to evade the rules, "including by dividing any loan transaction into separate parts".

The label is a trigger, not a finding. A loan can be a high-cost mortgage because it is small, short and secured by a manufactured home, where ordinary fixed costs eat a large share of a small loan amount, without anyone having done anything abusive. The consequence of the label is that a specific list of terms becomes unavailable and a specific list of steps becomes mandatory. Whether a loan is abusive is a separate question with its own vocabulary.

Testing a loan runs in a fixed order. The creditor determines the annual percentage rate under 1026.32(a)(3), using the rate in effect on the day the rate was set for a fixed-rate loan, the index plus the maximum margin (or the introductory rate, whichever is greater) for an indexed loan, and the maximum rate possible for any other variable loan. It compares that figure with the average prime offer rate published for a comparable transaction. It totals points and fees under 1026.32(b)(1) and compares them with the applicable percentage for the loan's size. It reads the contract for a prepayment penalty that could run past 36 months or exceed 2 percent of the amount prepaid. If any one test is met, the loan is a high-cost mortgage, and the creditor must strip out the forbidden terms, deliver the 1026.32(c) disclosure, and collect the counseling certificate before closing.

Take an example. Mateo is refinancing $150,000 against his home on a first lien. His annual percentage rate is 9.25 percent and the average prime offer rate for a comparable transaction that day is 6.10 percent, a spread of 3.15 percentage points. That is well under the 6.5-point first-lien threshold, so the rate test is not met. His loan amount is far above the indexed small-loan figure, so the 5 percent fee test applies. Points and fees, after the regulation's exclusions, come to $8,250. Dividing $8,250 by $150,000 gives 0.055, or 5.5 percent, which is above 5 percent, so the fee test is met and the loan is a high-cost mortgage even though its rate is nowhere near the rate trigger.

What changes for Mateo. The lender may not add the $8,250 to the loan amount, because financing points and fees is prohibited on a covered loan. He must obtain counseling from a HUD-approved counselor, after receiving his cost disclosures and from someone unconnected to the lender. The note may not carry a prepayment penalty, a rate increase on default, or a balloon payment. If the lender instead trims $800 of its own retained fees, points and fees fall to $7,450; $7,450 divided by $150,000 is 0.04967, or about 4.97 percent, and the loan is below the threshold and outside the rules. That small a margin is why the fee calculation, rather than the interest rate, is where most of these loans are won or lost.

Pros

• The tests are objective and published, so a borrower can ask for the APR, the average prime offer rate and the points-and-fees total and check the result.
• The forbidden-terms list removes the specific features that turn an expensive loan into an unpayable one, including balloon payments, growing balances and default rate increases.
• The counseling requirement puts an independent person, chosen freely and unconnected to the lender, in front of the borrower before signing.
• Barring the financing of points and fees means the cost has to be paid visibly rather than folded into a larger balance.

Cons

• The rules restrict terms; they do not require anyone to lend. A lender unwilling to carry the restrictions and the assignee liability can decline to make a covered loan at all, so for a borrower sitting just over a threshold the practical effect can be no offer rather than a better one.
• The fee trigger scales awkwardly to small loans, so a modest loan on a manufactured home can be covered on ordinary fixed costs alone.
• Two of the thresholds move every January, so a figure taken from last year's commentary can put a loan on the wrong side of the line.
• The label says nothing about whether a particular loan is fair. A loan can clear all three tests and still be a poor deal, and a covered loan can be the best option a borrower has.