Texas Home Equity Loans: How Not to Apply Equity Loan Proceeds?

It's not an exaggeration to state that originating a home equity loan in Texas can be perilous to any mortgage lender or financial institution.  The perils lie in the numerous restrictions, limitations, and requirements provided in the Texas Constitution and the Texas Administrative Code.

One of the restrictions relates to how to apply the proceeds from a Texas home equity loan.

Article 16, Section 50 (a)(6)(Q) of the Texas Constitution requires that a home equity loan is made on the condition that:

(i) the owner of the homestead is not required to apply the proceeds of the extension of credit to repay another debt except debt secured by the homestead or debt to another lender;

In addition, Section 50(a)(6)(g) requires the lender to provide each owner of the collateral property a disclosure at least 12 calendar days before closing a home equity loan.  The disclosure, commonly loan as the "12-Day Notice", must notify the recipient that the lender does

NOT REQUIRE YOU TO APPLY THE PROCEEDS TO ANOTHER DEBT EXCEPT A DEBT THAT IS SECURED BY YOUR HOME OR OWED TO ANOTHER LENDER

Texas Administrative Code (TAC), Title 7, Part 8, Article 153 was promulgated by the Texas Finance Commission to provide additional regulatory guidance regarding home equity lending in Texas. Section 153.18 provides:

An equity loan must be made on the condition that the owner of the homestead is not required to apply the proceeds of the extension of credit to repay another debt except debt secured by the homestead or debt to another lender.   (1) The lender may not require an owner to repay a debt owed to the lender, unless it is a debt secured by the homestead. The lender may require debt secured by the homestead or debt to another lender or creditor be paid out of the proceeds of an equity loan.  (2) An owner may apply for an equity loan for any purpose. An owner is not precluded from voluntarily using the proceeds of an equity loan to pay on a debt owed to the lender making the equity loan.

In other words, in originating a Texas home equity loan, the lender should not require the borrower to use the loan  proceeds to repay another debt owed to the lender unless the previous debt was secured by a lien against the homestead (e.g., purchase money lien, deed of trust lien, or a home equity lien). However, the lender may require the loan proceeds to be applied toward other debts owed to other creditors (e.g., tax lien, credit card debt, etc.)

According to the TAC, a borrower may voluntarily apply the loan proceeds from a home equity loan toward another debt owed to the same lender.  Lenders should, however, be cautious in doing so because it may have to prove to a court that the use of the loan proceeds was indeed voluntary in the event of a future default.  One can easily anticipate a defaulting borrower arguing otherwise when facing foreclosure. 

Texas Supreme Court Further Clarifies Home Equity Lending

Summary:

In a Supplemental Opinion On Motion for Rehearing dated January 24, 2014, the Supreme Court of Texas ruled that: (1) per diem interest and legitimate discount points are not included in the constitutional 3% fee cap in connection with Texas home equity loans secured by homestead; and (2) a power of attorney can only be used in closing a home equity loan if that power of attorney was properly executed in the office of a title company, an attorney, or of the lender.

Impact:

With this additional ruling from the high court, lenders can now exclude prepaid per diem interest from the 3% fee cap.  "Legitimate" discount points can also be excluded, but the Court did not define what constitutes "legitimate".  The intent of the Court was, probably, to state "bona fide" discount point, which is a concept familiar to the mortgage lending industry.  Like with the exclusion of bona fide discount points in calculating the QM 3%, lenders will likely be required to demonstrate the discounts were in fact bona fide.  It's possible the Court may issue additional clarification on "legitimate discount points", and I will continue to monitor for developments on this.  For lenders that only originate QM loans, they will need to comply with both the Texas 3% fee cap and QM 3% when the Texas home equity loan amount is equal to or greater than $100K. 

In addition, borrowers, who must sign closing documents with the help of a power of attorney, will have to execute a Power of Attorney in the office of an attorney, the lender, or title company.  As a practical matter, title companies that close Texas home equity loans may require evidence, proof, or certification that a Power of Attorney was indeed executed in one of the permitted locations.  To be safe, a lender should not allow an agent/attorney-in-fact to execute Texas home equity loan closing documents unless it is certain that the power of attorney giving authority to the agent was properly executed in the office of a title company, an attorney, or of the lender.