The Dodd-Frank Act and Its Impact on Financing Home Sales

Financing for residential purchases including seller financing and unlicensed third-party lenders has been substantially affected by the Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly called the “Dodd-Frank Act” which was passed in 2010 and implemented over the next three or four years.

While the Dodd-Frank Act is very comprehensive and affects virtually all aspects of lending, this article is limited to a discussion of seller financing and third-party financing for residential properties. The Act applies to residential loans when the borrower will live in the residence. Loans secured by vacant land, commercial properties, investment rental properties, even if they are residences, are not subject to the Act.

The person who arranges a loan secured by a property that the borrower will use for residential purposes, whether the loan is for a primary residence, a second home, or a vacation home, is defined by Dodd-Frank as a “loan originator” and must have a loan originator license. Seller financing must be arranged by a licensed mortgage originator unless the financing qualifies for one of the two exceptions discussed below. There are no exceptions for unlicensed third-party lenders.

The last sentence bears repeating. There are no exceptions for unlicensed third-party lenders. Even loans by a parent to a child violate the act if the loan is secured by a mortgage against residential property to be used by the child as a residence. If a parent chooses to make an unsecured loan to a child and does not take a lien against the property, the child will not qualify to deduct the interest on his or her tax return.

There are two exceptions for seller financing called the “one property exception” and the “three property exception”.

To qualify for the “one property exception”:
The seller must:

(a) be a natural person, estate, or trust (loans from entities such as corporations or limited liability companies are not permitted);
(b) provide financing for only one property in a twelve-month period;
(c) own the property sold which will secure the financing; and
(d) not have constructed the residence on the property (builders cannot use this exception).

The loan must:

(a) not have a negative amortization;
(b) not have a balloon payment due in less than five years; and
(c) have a fixed interest rate or an adjustable rate that resets after five or more years and cannot increase over two points per year or six points during the life of the loan.

A seller who qualifies under the “one property rule” need not comply with the ability to repay rules. This is important because the ability to repay rules are a set of rules that a lender must comply with to determine the ability of a borrower to repay the loan. These rules can be a little over whelming for many unlicensed lenders and under the one property rule, the seller-lender is exempt from compliance.

To qualify for the “three property exception”:
The seller must:

(a) be a natural person, estate, or trust (loans from entities such as corporations or limited liability companies are not permitted);
(b) provide financing for three or fewer properties in a twelve-month period;
(c) own the property sold which will secure the financing;
(d) not have constructed the residence on the property (builders cannot use this exception); and
(e) must comply with the ability to pay rules.

The loan must:

(a) not have a negative amortization;
(b) be fully amortizing and not have a balloon payment; and
(c) have a fixed interest rate or an adjustable rate that resets after five or more years and cannot increase over two points per year or six points during the life of the loan.

To comply with the ability to pay rules the seller must make a good faith effort to determine that the borrower has a reasonable ability to repay the loan. Although a seller does not have to formerly document that they made their good faith determination that the borrower could repay, it would be prudent to document how the determination was made if it is challenged. The analysis of ability to pay should include documented income and assets, income tax returns, employment, monthly debt payments, debt obligations, debt to income ratios, credit history, etc.

The primary difference between the one property and three property rules is that under the three property rule no balloon payment is allowed and the ability to pay rules are in effect.

If a seller does over three loans per year

(a) A licensed mortgage originator must originate the loan;
(b) No balloon payment is allowed;
(c) The ability to pay rules apply; and
(d) The loan must have a fixed rate of interest or an adjustable rate that resets after five or more years and cannot increase over two points per year or six points during the life of the loan.

A lender subject to the Act and cannot fit within one of the exceptions can still make a loan by retaining a licensed, independent loan originator, commonly called a mortgage broker, to originate the loan. The mortgage broker must comply with the various lending laws and regulations, including the Dodd-Frank Act, the SAFE Act, RESPA, the Truth In Lending Act, and Regulation Z. Since the mortgage broker will be lending the seller-financer’s or individual lender’s money, the broker may be considered the agent of the seller-financer or individual lender which could make the seller or third-party lender liable if there is a failure to comply with the lending laws and regulations. Therefore, the seller-financer or individual lender should use only a competent and knowledgeable mortgage broker.

There is good news and bad news if a lender makes a loan in violation of Dodd-Frank. The good news is that the government has not been aggressive in enforcing the Act against individual lenders. The bad news is that the penalties for violation are harsh including penalties ranging from $4,000 per day up to $25,000 for reckless violations and $1,000,000 per day for knowing violations.

Even if there is no government enforcement, the Act grants a private right to sue. That means that a borrower aggrieved by a violation of the Act may sue to rescind the loan, and request a refund of all interest paid, release of the liens securing the loan, payment of attorney fees and other relief. Even a parent making a loan to a child and his or her spouse should be concerned that in the event of a subsequent divorce, violating the Act could provide potent leverage to an aggrieved spouse.

The information in this article is generalized and is for education only. It is not intended as legal advice. Anyone considering making a loan which might be subject to the Dodd-Frank Act should seek competent legal advice before making the loan.

If you are a seller and fit within one of the exceptions to the Act, the mechanics of making a seller financed loan are discussed in another article which you can access here.