Consumer Compliance Outlook > 2009 > First Quarter 2009

by Alan Dombrow, Examining Officer, and Ken Shim, Senior Examiner, Federal Reserve Bank of New York

In a previous issue of *Consumer Compliance Outlook*, John S. Insley from the Federal Reserve Bank of Richmond discussed a fast-growing credit product called a reverse mortgage and its potential compliance risks.^{1} This article will review the disclosure requirements under Regulation Z for reverse mortgage transactions and also explain the steps in computing the total annual loan cost rate, or TALC rate, required by Regulation Z using the examples found in Appendix K to Regulation Z.

The TALC rate is an annual percentage cost of a reverse mortgage. Unlike the annual percentage rate (APR), which takes into account only the finance charges in a credit transaction, the TALC rate considers all costs, which is why it is named the total annual loan cost. In addition to finance charges, the TALC rate may reflect other costs, such as annuity premiums, appraisal fees and other closing costs, and a percentage of any appreciation in the consumer's house.

The following scenario illustrates the difference between an APR and the TALC in calculating the amount financed.

APR | TALC | |
---|---|---|

Loan requested | $105,000 | $105,000 |

Nonfinance charges financed | 3,000 | 3,000 |

Prepaid finance charges | 2,000 | 2,000 |

Loan amount | $110,000 | $110,000 |

Nonfinance charges financed | -$3,000 | |

Prepaid finance charges | -$2,000 | -$2,000 |

Amount financed | $108,000 | $105,000 |

The amount financed for the APR is higher because only the prepaid finance charges are subtracted from the $110,000 loan amount, whereas the amount financed for the TALC rate calculation subtracts all charges, including nonfinance charges. Typically, this difference translates to a higher TALC rate compared to the APR.

Section 226.33 of Regulation Z requires reverse mortgage creditors to disclose a good faith projection of the total cost of the credit to the consumer in a tabular format similar to the matrix disclosure currently required by the Department of Housing and Urban Development's (HUD) Home Equity Conversion Mortgage (HECM) program, a reverse mortgage insured by the Federal Housing Administration.

The regulation also requires creditors to use the term "total annual loan cost rate" to avoid any confusion with the APR and to more accurately describe the percentage cost of reverse mortgages. In projecting the total cost of credit, TALC rates must be based on three credit transaction periods: two years, a period equal to the youngest consumer's life expectancy, and a period equal to 1.4 times the youngest consumer's life expectancy. Appendix L^{2} to Regulation Z provides life expectancy figures based on U.S. Decennial Life Tables published by the Department of Health and Human Services. The regulation also adds an optional loan period that the creditor may disclose equal to one-half of the youngest consumer's life expectancy.

In addition to the loan periods mentioned above, TALC rates must also be based on assumed annual house appreciation rates of 0 percent, 4 percent, and 8 percent. The 4 percent annual appreciation rate comes from HUD's assessment of long-term averages of historical housing appreciation. The 0 percent and 8 percent annual appreciation rates were included to help consumers understand the potential costs and benefits if the dwelling does not appreciate in value at all or if it appreciates at a rate faster than the average.

The projected total cost of credit must reflect all costs and charges to the consumer, including the costs of any annuity that the consumer purchases as part of the reverse mortgage transaction. Some creditors require or allow consumers to purchase an annuity as part of the transaction that immediately, or at some time in the future, supplements or replaces the creditor's payments. The regulation requires that the amount paid by the consumer for the annuity must be included as a cost to the consumer, regardless of whether the purchase is made through the creditor or a third party and regardless of whether the purchase is mandatory or voluntary.

All advances made for the benefit of the consumer, including annuity payments, must be reflected in the projected total cost of credit. Also, any shared appreciation or equity that the creditor is entitled to receive pursuant to the credit contract, and any limitation on the consumer's liability, such as equity conservation agreements, must be considered. An equity conservation agreement is an agreement limiting the consumer's liability to a specific percentage of the net proceeds available from the sale of the home. If a contract does not specify a percentage for net proceeds, creditors must assume 7 percent, which approximates the amount paid for typical brokerage fees and other incidental costs.

In addition to the good faith projection of the total cost of the credit as explained above, the regulation requires creditors to provide the following information in a form substantially similar to the model form found in paragraph (d) of Appendix K:^{3}

- A statement that the consumer is not obligated to complete the reverse mortgage transaction because the consumer has received the disclosures or has signed an application for a reverse mortgage loan.
- An itemization of loan terms, charges, the age of the youngest borrower, and the appraised property value.
- An explanation of the table of total annual loan cost rates.

The disclosures must be provided to the consumer at least three business days before consummation of a closed-end credit transaction or before the first transaction under an open-end credit plan.^{4}

Before discussing an example from Appendix K, four important assumptions must be made in order to calculate the TALC rate:

- Assume that reverse mortgage transactions begin on the first day of the month in which consummation is estimated to occur. In other words, assume no odd days.
- For those reverse mortgages in which the consumer controls the timing of advances made after consummation (such as in a credit line), assume that 50 percent of the principal loan amount is advanced and that no further advances are made during the remaining term of the loan. In that regard, the transaction is treated as closed-end credit for TALC rate calculation purposes.
- For variable-rate reverse mortgage transactions, assume that the initial interest rate will not increase. If the initial interest rate is a discounted rate, the discounted rate must first be applied for the period that it will be in effect. For the remaining term, apply the original rate without the discount to compute the TALC rate, similar to the requirements set forth in section §226.17(c).
- Assume that all closing and other consumer costs are financed.

The last example in Appendix K [(d)(2), Sample Form] is the combination of a lump-sum advance, monthly advances, and a credit line. The borrower receives a lump-sum advance of $1,000, plus a $301.80 monthly advance at consummation. The borrower will receive a monthly payment of $301.80 for the 12-year term of the loan. In addition, the borrower has a $4,000 line of credit.

Lump-sum to borrower | $1,000 |

Monthly payments to borrower | $301.80 |

Total loan costs financed | $5,000 |

Credit line | $4,000 |

Contract interest rate | 9% |

Assumed annual dwelling appreciation rate | 4% |

Appraised value of property | $100,000 |

Age of the youngest borrower | 75 |

Estimated loan term | 12 years |

Equity reserved | 7% |

N | I | PV | PMT | FV |
---|---|---|---|---|

144 months | 0.75% (HP 12c) 9% (HP 17bII) |
$301.80 | ? | |

144 months | 0.75% (HP 12c) 9% (HP 17bII) |
$1,000 (initial advance) | ? | |

144 months | 0.75% (HP 12c) 9% (HP 17bII) |
$2,000 (1/2 of credit line)^{5} |
? | |

144 months | 0.75% (HP 12c) 9% (HP 17bII) |
$5,000 (total loan costs) | ? |

I = 9% contract rate divided by 12 months in a year = 0.75%

When calculating the future value of monthly payments, the calculator must be set to BEG mode (payments made at the beginning of the month).

**For the HP 17bII, the P/YR must be set to 12 (12 payments per year).**

FV ($301.80 monthly for 12 years) | = $78,360.68 |

FV ($1,000 after 12 years) | = $2,932.84 |

FV ($2,000 after 12 years) | = $5,865.67 |

FV ($5,000 after 12 years) | = $14,664.18 |

FV of all advances | = $101,823.37 |

N | I | PV | FV |
---|---|---|---|

12 | 4% | $100,000 | ? |

I = Assumed annual dwelling appreciation rate |

**For the HP 17bII, the P/YR must be set to 1 (one payment per year).**

FV = $160,103.22

The repayment amount is the lesser of the FV of all advances **($101,823.37)** or the FV of the dwelling minus the equity reserved:

($160,103.22—$11,207.23[7% of FV of dwelling]= **$148,895.99**).

Repayment Amount = $101,823.37

Below are the entries for the APRWin program:

Loan Information | |

Amount Financed: | $3,301.80 ($1,000 lump-sum + $301.80 first monthly advance + one-half of $4,000 credit line) |

Disclosed APR: | 11.03% (If the disclosed TALC rate is being verified, enter the disclosed rate here. If the TALC rate is being calculated, enter an estimated rate, e.g., 1.) |

Disclosed Finance Charge: | Leave blank |

Loan Type: | Installment Loan |

Payment Frequency: | Monthly |

Payment Stream # | Payment Amount | Number of Payments | Unit Periods | Odd Days |
---|---|---|---|---|

1 | -301.8 | 143 | 1 | 0 |

2 | 101823.37 | 1 | 144 | 0 |

*Payment Stream #1* — **The payment amount must be entered as a negative value.** The number of payments is the remaining number of advances left after the initial advance at consummation.

*Payment Stream #2* — The payment amount is the repayment amount from Step 3.

**APR = 11.03% (This is the TALC rate based on the multiple advances to the borrower [$301.80 x 144 = $43,459.20], $1,000 initial advance, $2,000 credit line outstanding, and the $101,823.37 payment.)**

In the previous example, the TALC rate was calculated based on a 12-year loan term with an assumed annual appreciation rate of 4 percent, but that is just one of nine TALC rates that must be disclosed. Section 226.33(c) of Regulation Z requires creditors to disclose TALC rates based on three loan terms as determined by the life expectancy of the youngest borrower in accordance with Appendix J to Regulation Z, and to assume annual appreciation rates of 0 percent, 4 percent, and 8 percent for the dwelling.

Below is the reverse mortgage disclosure for the example. (Note that the TALC rates based on a six-year loan term, which is one-half of the life expectancy of the youngest borrower, are optional):

TOTAL ANNUAL LOAN COST RATE | ||||
---|---|---|---|---|

Loan Terms | Monthly Loan Charges |
|||

Age of youngest borrower: | 75 | Service fee: | None | |

Appraised property value: | $100,000 | |||

Interest rate: | 9% | Other Charges |
||

Monthly advance: | $301.80 | Mortgage insurance: | None | |

Initial draw: | $1,000 | Shared appreciation: | None | |

Line of credit: | $4,000 | Repayment Limits |
||

Initial Loan Charges |
Net proceeds estimated at 93% of projected home sale | |||

Closing costs: | $5,000 | |||

Mortgage insurance premium: | None | |||

Annuity cost: | None | |||

Assumed Annual Appreciation | 2-year loan term | [6-year loan term] | 12-year loan term | 17-year loan term |

0% | 39.00% | [14.94%] | 9.86% | 3.87% |

4% | 39.00% | [14.94%] | 11.03% | 10.14% |

8% | 39.00% | [14.94%] | 11.03% | 10.20% |

The cost of any reverse mortgage loan depends on how long you keep the loan and how much your house appreciates in value. Generally, the longer you keep a reverse mortgage, the lower the total annual loan cost rate will be. The table above shows the estimated cost of your reverse mortgage loan, expressed as an annual rate. It illustrates the cost for three [four] loan terms: two years, [half of life expectancy for someone your age], that life expectancy, and 1.4 times that life expectancy. The table also shows the cost of the loan, assuming the value of your house appreciates at three different rates: 0 percent, 4 percent, and 8 percent. The total annual loan cost rates in this table are based on the total charges associated with this loan. These charges typically include principal, interest, closing costs, mortgage insurance premiums, annuity costs, and servicing costs (but not disposition costs—costs when you sell the home). The rates in this table are estimates. Your actual cost may differ if, for example, the amount of your loan advances varies or the interest rate on your mortgage changes. SIGNING AN APPLICATION OR RECEIVING THESE DISCLOSURES DOES NOT REQUIRE YOU TO COMPLETE THIS LOAN. |

Additional Examples Are Available | |||
---|---|---|---|

## Example 2 |
## Example 3 |
## Example 4 |

Creditors who fail to comply with the requirements of §226.33 may face civil liability under the Truth in Lending Act. Regulation Z does not provide an accuracy tolerance for TALC rate disclosures, as it does for APR disclosures. As a result, the smallest deviation from the actual rate may trigger a violation.

In a successful action brought by a borrower, creditors may be assessed a penalty in an amount equal to the sum of any actual damage sustained by the borrower, in addition to attorney's fees and court costs. In the case of individual actions, the penalty can be twice the amount of the finance charge (minimum $100, maximum $1,000 for open-end credit; minimum $400, maximum $4,000 for closed-end credit), and in the case of a class action, up to the lesser of $500,000 or 1 percent of the creditor's net worth. Specific issues and questions should be raised with the consumer compliance contact at your Reserve Bank or with your primary regulator.

- 1 John S. Insley, Jr., "Reverse Mortgages and Consumer Protection," Consumer Compliance Outlook (Third Quarter 2008).
- 2 "http://edocket.access.gpo.gov/cfr_2008/janqtr/pdf/12cfr226AppL.pdf
- 3 http://edocket.access.gpo.gov/cfr_2008/janqtr/pdf/12cfr226AppK.pdf
- 4 12 C.F.R. 226.31(c)(2)
- 5 For a credit line, the TALC must be based on the assumption that 50 percent of the line of credit is outstanding at closing. TALC rate calculations effectively treat the transaction as a closed-end credit transaction after that.

Copyright 2014 Federal Reserve System. This material is the intellectual property of the Federal Reserve System and cannot be copied without permission.

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