Friday, March 21, 2014

Dodd-Frank: Are Investors Who Offer Seller Financing Too Big to Fail?

Our latest post talked about lease-options and how they worked. Lease-options can offer home ownership to people who may otherwise not qualify for traditional financing when they want to buy a home. Many, if not most, lease-option deals today include seller financing. Moreover, in many rural areas, sellers often use land contracts, which are also a form of seller financing.

But seller financing had some pitfalls. Many contracts contained interest rate adjustments that were punitive, while others featured balloon payment clauses that most buyer-borrowers couldn't pay. The Wall Street Reform and Consumer Protection Act, affectionately know as Dodd-Frank, has something to say about the issue. This law is the most significant piece of lending oversight legislation passed since the Great Depression.

Lease-option-type investors who offer seller financing are deemed to be "loan originators" under the statute and therefore must abide by the same underwriting rules that mortgage brokers and lenders have to follow. They must verify, for example, that their buyer-borrower customers fall within prescribed debt-to-income limits and, in general, have the ability to pay the loan. Loan originators must also abide by the Truth-in-Lending Act (TILA).

All seller-carryback loans must be fully amortizing, that is, they may not have balloon payments. If the interest rate is adjustable, the  index it adjusts to must be "reasonable," such as LIBOR, and adjustments are subject to both annual and lifetime limits. While most investors who offer seller financing are fair and legitimate business people, some are unscrupulous and have employed onerous loan terms that would, in effect, cause borrowers to default and lose their option and loan payments.

The law makes exceptions for certain small investors that allow for relief of some of the rules. However, even these investors must abide by the rules in the preceding paragraph, even as they are exempt from SAFE (see below).

Lay people and most real estate professionals don't realize that Dodd-Frank isn't regulatory, that is, it can't come in and shut down seller-finance investors who abuse the rules. All Dodd Frank does is give consumers grounds for litigation. The relief granted, though, is significant and pretty much gives consumers all their money back plus some. Who wins and loses the suit is pretty clear cut, but the aggrieved party still has to litigate.

However, the state SAFE Act (Secure and Fair Enforcement of Mortgage Licensing Act), signed by President Bush in 2008, is regulatory. This law requires state licensing of mortgage originators under state laws that meet federal standards. Since this law is regulatory, its enforcers can shut down violators.

All this may seem kind of complex. That's because it is. Questions? Give me a shout.