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Consumer Credit Regulation: 4.1 Introduction

This chapter deals with the interpretation of state law restrictions on interest and other charges in credit transactions. In the wave of deregulation that started in the 1980s, some states reduced or even eliminated their restrictions on the cost of credit. However, in many states such statutes remain in force and are the key bulwark against predatory non-mortgage lending. Moreover, even states that repealed most of their caps on interest and other charges often proceeded piecemeal, leaving some restrictions on the books for some types of extensions of credit.

Consumer Credit Regulation: 4.2.1 General Interpretation of “Interest”

Where a law restricts the costs of credit by imposing a restriction on “interest,” the key question is what constitutes interest. As this chapter discusses, if interest were narrowly defined as the application of a percentage rate over a period of time, a cap that restricted only interest would have little effect, as the lender could hide all the cost of credit in other fees and charges.

Consumer Credit Regulation: 4.2.3 Statutes That Exclude Enumerated Charges from Interest or the Finance Charge

Some statutes that cap “interest” set forth a general definition of the term, and then specify charges that are excluded from the definition.46 Statutes that cap the “finance charge” for a transaction rather than capping “interest” are often structured this way as well.47 (The term “finance charge” is more clearly intended as an all-inclusive term than “interest,” so there is less likely to be controversy about whether the term includes charges that are not based on application of a percentage rate

Consumer Credit Regulation: 4.3.1 General

One type of ostensibly non-interest charge that is often used and misused by lenders is a fee calculated as a percentage of loan principal. Depending on the type of lender and loan involved, this fee may be variously described as an “origination fee,” “commitment fee,” “service charge,” or “loan fee,” but is perhaps best known as “points” or “discount points,” with one point being a sum equal to one percent of the loan principal.

Consumer Credit Regulation: 4.3.2 Legal Considerations

When statutes do not specifically address the treatment of points and similar fees, lenders carry the burden of demonstrating that points are justified by actual recognized costs associated with a loan and are not merely extra profit or compensation for overhead expense.66 This is a burden that lenders can seldom carry, and numerous courts have found points and similar fees to constitute hidden interest.67

Consumer Credit Regulation: 4.4.1 Introduction

Interest can be hidden by exaggerating the amount of principal which a borrower has received. The idea behind inflating the principal amount is essentially a variation on the use of discount interest.88 To use a simplistic example, a borrower might receive $100 from a lender while signing a note obliging him or her to pay back $120 in “principal” a year later.

Consumer Credit Regulation: 4.4.2 Fees Added to Principal; General Methods of Overstating Principal

The most common technique used to inflate loan principal is the inclusion of various fees in the face amount of the note.91 Assume that a borrower applies for a $1,000 loan. The lender approves the loan but tells the borrower that she will have to pay a $10 credit investigation fee, a $20 service charge, and $70 for credit property insurance on her car which, by the way, she will have to provide as security.

Consumer Credit Regulation: 4.4.3 Indexing Loan Principal

A less common method of inflating loan principal is to adjust the principal periodically to compensate for currency inflation or some other factor, for example by pegging the principal to the consumer price index.108 If the consumer price index shows a 5% inflation rate for each of several years, and the contract provides for annual adjustments, the outstanding loan principal would be multiplied by a factor of 1.05 at the end of each year. Payments for the subsequent year would be calculated using this adjusted principal amount.

Consumer Credit Regulation: 4.4.4 Compensating Balances

Another method through which a creditor may overstate the principal amount of a loan, and thereby understate the true interest rate, is to require that the borrower maintain an account with the lender with a minimum deposit of, perhaps, ten percent of the stated amount of the loan. This “compensating balance,” which remains in the lender’s control, is frequently described as “security” which is supposed to guarantee payments on the loan. In fact, it is just another form of discount because the borrower is paying interest on a larger sum than he or she is actually receiving.

Consumer Credit Regulation: 4.4.5 Inflating the Sale Price

Interest can be hidden in the price of goods purchased on credit in the same manner that it is concealed in the principal amount of a loan. For example, a seller can offer low-rate financing, but then simply jack up the price of the product for buyers who take advantage of the offer.

Consumer Credit Regulation: 4.4.6 Seller’s Points

A special method by which interest costs may be hidden in the sale price of goods or real estate is the use of “seller’s points.” Seller’s points occur most frequently in real estate transactions when the real estate seller, typically a builder, pays points to a bank or other lender in return for the lender’s commitment to issue “low-interest” loans to qualified buyers. Such an arrangement might appear to be a boon to buyers and, indeed, seller’s points would not be deceptive or usurious, if the seller did not recover its expense by raising the selling price of the real estate.

Consumer Credit Regulation: 4.5.1 General Principles

Credit contracts frequently contain not only fees which are assessed for various lender services, but also fees collected by the lender on behalf of third parties who have, in fact or theory, provided some service to the borrower in connection with the contract. Third-party payments may cover a myriad of services: broker fees, appraisal fees, recording fees, credit insurance, inspection fees, and attorney fees, to name but a few.

Consumer Credit Regulation: 4.5.2.1 Sham Third Parties

Despite the general rule that bona fide third-party payments are not interest or components of the finance charge, usury laws could easily be circumvented if a subsidiary or agent of the lender could collect non-interest payments on the lender’s behalf. Accordingly, courts have held that payments to a creditor’s agents or employees are not bona fide third-party payments.135

Consumer Credit Regulation: 4.5.2.3 Services That Primarily Benefit the Lender

Another hidden interest issue in third-party payments is whom the services really benefit. Some services provided by third parties benefit both the creditor and the borrower. Credit insurance, for example, guarantees payment of outstanding debt if the debtor becomes ill or if the collateral is damaged. If both the creditor and the debtor benefit from the guarantee, the existence of some lender benefit will not alone demonstrate hidden interest.147

Consumer Credit Regulation: 4.5.2.4 Sham Services

Lenders may also increase the cost of credit surreptitiously by charging borrowers for sham services that are not in fact provided.152 Charges for services that the lender does not in fact perform are interest.153 For example, courts have held payments to lenders under sham consulting contracts to be interest.154

Consumer Credit Regulation: 4.5.3.1 Where Broker Is Related to the Lender

Loan broker commissions added to the principal may often be hidden interest. While loan brokers represent that they provide a service to the consumer by finding the best loan, often they have a relationship with just one lender and steer consumers to that lender, who does not offer the best deal.

Consumer Credit Regulation: 4.5.3.2 Where Lender and Broker Split the Broker Fee

Where the lender and the broker split an interest rate upcharge, this is often called a “yield spread premium.”175 The Alabama Supreme Court permitted a case that alleged this arrangement to be a concealed device to evade the state’s 5% cap on points to go to the jury.176 However, to the extent the decision held that a yield spread premium constituted “points” under a state law capping the number of points a lender can charge, the court overruled itself in a later decision.

Mortgage Lending: 3.3.1 Introduction

In analyzing a mortgage loan transaction it is helpful to look at where the money goes, to determine what portion of the loan proceeds benefits the borrower, what portion benefits the lender, and what portion goes to third parties. For this analysis it is absolutely necessary to have some document that itemizes the components of the note principal or amount financed.

Consumer Credit Regulation: 4.5.3.3 State Statutes Regulating Brokers

The 2008 SAFE Mortgage Licensing Act requires all states to have at least a basic licensing system for mortgage loan brokers.180 Non-mortgage loan brokers are also expressly regulated in most states. Some of these states also cap the fees that loan brokers may charge.181 However, these statutes frequently contain broad loopholes.182