By Kelly Walsh, Senior Examiner, Federal Reserve Bank of San Francisco
When pricing mortgage loans, many creditors offer borrowers the option of obtaining a lower interest rate by purchasing discount points. These points, paid in an upfront lump sum, lower the amount of interest paid over the life of the loan. Generally speaking, each discount point costs 1 percent of the total loan amount and usually lowers the interest rate by 25 basis points. For example, for a $200,000 mortgage loan with a 5 percent par interest rate, two discount points would cost $4,000 and would lower the interest rate by 50 basis points, to 4.50 percent.
Both borrowers and creditors potentially benefit from discount points. Borrowers gain the benefit of lower interest payments over the life of the mortgage, although the trade-off of an upfront payment in exchange for lower monthly payments involves a payback period and usually requires the borrower to retain the mortgage for a period of time to achieve a net gain. Discount points are also generally tax deductible.1
Creditors benefit by receiving a cash payment, which enhances their liquidity. However, creditors must ensure that discount points are not “unearned.” In other words, creditors must ensure that their mortgage loan officers do not engage in the practice of charging a fee for a service but failing to provide the service. The term unearned discount points describes points paid by borrowers that did not result in a reduction in the loan’s par interest rate.
Charging unearned discount points has compliance implications. This practice could violate the prohibition in section 5(a) of the Federal Trade Commission (FTC) Act against unfair or deceptive acts or practices (UDAP).2 The practice could also have fair lending implications under the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA) if it has an illegal disparate impact. Discount points are also the focus of a recent rulemaking proposal under Regulation Z issued by the Consumer Financial Protection Bureau (CFPB). This article discusses the compliance risks for creditors charging unearned discount points under the FTC Act, the ECOA, the FHA, and the CFPB’s rulemaking proposal.
Under the FTC Act, an act or practice is deceptive when (1) the representation, omission, or practice misleads or is likely to mislead the consumer, (2) the consumer’s interpretation of the representation, omission, or practice is reasonable under the circumstances, and (3) the misleading representation, omission, or practice is material. See 15 U.S.C. §45(a).3
Charging unearned fees may be considered deceptive for the following reasons. First, by falsely representing on the HUD-1 Settlement Statement that points are discount points, a financial institution could mislead customers into believing they were receiving a discount off the par interest rate. When evaluating the facts, examiners could consider whether loan officers knew, prior to loan closing, what the interest rate deduction should have been relative to the discount points charged and whether borrowers were informed that either the discount fees would not result in a proportional discount in the interest rate or that no discount would be provided.
With respect to the second element of a deceptive act or practice, “The test is whether the consumer’s expectations or interpretation are reasonable in light of the claims made.”4 If a financial institution represents to consumers that they can lower their mortgage loan rate by paying discount points, and those points are itemized on the final HUD-1 Settlement Statement, consumers may reasonably believe that the lender will provide an appropriately discounted interest rate.
Finally, the misrepresentation would be considered material if it concerned a sufficiently large amount of unearned fees or affected a large group of borrowers. Claims made with the knowledge that they are false should be presumed to be material. For example, a financial institution’s knowledge that fees disclosed as discount points on a HUD-1 Settlement Statement were not, in fact, resulting in a commensurate discount to borrowers would be presumed material.
While the practice of charging unearned discount points has the potential to violate section 5(a) of the FTC Act, it is important to emphasize that every UDAP case depends on its specific facts and circumstances.
Charging unearned discount points can also have fair lending implications. If a creditor charges discount points without actually lowering the rate and the practice has an illegal disparate impact, the practice could violate the ECOA, as implemented by Regulation B, and the FHA.
Regulation B prohibits discrimination against an applicant on a prohibited basis (race, color, religion, national origin, sex, marital status, age, receipt of public assistance, or exercising rights under the Consumer Credit Protection Act) regarding any aspect of a credit transaction. See 12 C.F.R. §1002.4(a). As explained in the Official Staff Commentary, the ECOA and Regulation B “may prohibit a creditor practice that is discriminatory in effect because it has a disproportionately negative impact on a prohibited basis, even though the creditor has no intent to discriminate and the practice appears neutral on its face, unless the creditor’s practice meets a legitimate business need that cannot reasonably be achieved as well by means that are less disparate in their impact.”5 Similarly, section 3605 of the FHA prohibits discrimination in residential real estate transactions because of race, color, religion, sex, handicap, familial status, or national origin.
Consider this example: A creditor provides its loan officers discretion in setting interest rates and discount points for borrowers. In some cases, loan officers charged borrowers discount points without a commensurate reduction in the note rate. A statistical analysis of the borrowers reveals that the practice had a disparate impact on Hispanic borrowers. Of the 100 Hispanic borrowers, 40 paid unearned discount points (40 percent). Of the 80 non-Hispanic white borrowers, 20 paid unearned discount points (25 percent). In other words, approximately 40 percent of the Hispanic borrowers paid unearned discount points, compared to 25 percent of non-Hispanic white borrowers. This difference is statistically significant at the 5 percent level.
If the creditor in this scenario cannot offer a legitimate business justification for these disparities, the practice could constitute a pattern or practice of credit discrimination in violation of the FHA, the ECOA, and Regulation B. Section 706(g) of the ECOA, 15 U.S.C. §1691e(g), mandates a referral to the U.S. Department of Justice when a federal banking agency has reason to believe that a creditor has violated section 701(a) of the ECOA by engaging in a pattern or practice of discrimination and provides discretionary referral authority for individual violations of section 701(a), 15 U.S.C. §1691(a).
In Freeman v. Quicken Loans, Inc., 132 S. Ct. 2034 (2012), the U.S. Supreme Court recently narrowed considerably the circumstances in which an unearned fee will violate section 8(b) of the Real Estate Settlement Procedures Act (RESPA). The Supreme Court unanimously concluded, based on the statutory language, that a section 8(b) violation for an unearned fee must involve “a charge for settlement services [that] was divided between two or more persons.” Because the plaintiffs in Freeman did not allege that Quicken split discount points with anyone else, the court affirmed the dismissal of the case. It is important to note that while an unearned, undivided fee does not violate section 8(b) of RESPA, such a fee could still violate the other consumer protection laws discussed earlier.
On August 17, 2012, the CFPB issued a rulemaking proposal under Regulation Z to implement mortgage provisions in Title XIV of the Dodd-Frank Act, including a provision in section 1403 restricting discount points.6 To protect consumers while allowing creditors to continue offering mortgages with discount points, the CFPB proposed two requirements for discount points. First, the consumer must be offered an alternative loan that does not include discount points and origination points or fees (unless the consumer is unlikely to qualify for the alternative loan). Second, the borrower must receive a bona fide reduction in the interest rate of the loan with discount points compared to the interest rate on the alternative loan without discount points.7 Comments on the proposal are due by October 16, 2012. The CFPB expects to issue a final rule by January 21, 2013, as required by section 1400(c)(1) of the Dodd-Frank Act.
Management should ensure that compliance and residential lending staff understand the risks associated with unearned discount points. Policies, procedures, and controls related to mortgage loan pricing should be sufficient to prevent loan officers from representing to borrowers that the rate was lowered because the borrowers purchased discount points without actually lowering the rate. A lender’s pricing policy or guidelines should be specific and state that loan officers are prohibited from charging discount points that do not result in a proportional lowering of the interest rate.
Discount points may potentially provide significant benefit to both lenders and borrowers. However, charging unearned discount points can result in violations of laws and regulations and increased legal and reputational risks for financial institutions. Such violations could also result in required remediation to affected borrowers and other supervisory actions, including a possible referral to the U.S. Department of Justice if there is a fair lending violation.
To manage these risks and avoid potential violations associated with unearned discount points, lenders should ensure that loan policies require that discount points are only charged when a commensurate discount to the rate is provided and systems are in place to ensure that practices are aligned with these policies. Specific issues and questions should be raised with your primary regulator.
Complete Issue (3.44 MB, 20 pages)
Kenneth Benton, Editor
FEDERAL RESERVE SYSTEM
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