Right to Rescind: What Mortgage Lenders Should Know

In its recent and relatively short opinion in Jesinoski v. Countrywide Home Loans, Inc., the U.S. Supreme Court confirmed that a homeowner has the right to cancel a covered residential loan transaction for up to three years after the transaction is consummated.  But, the Court overturned the lower courts' (both the district court and the 8th Circuit) ruling that the homeowner must file a lawsuit within three years after the loan closes in order to cancel or rescind the loan.  To exercise that right, the Court held that the homeowner needs only send the lender a written notice of its intent to cancel within the three-year period.

Most lenders are familiar with a three-business-day rescission period on covered loan transaction, but this case involved a three-year rescission period.  Generally, to trigger the three-year rescission period, a lender must have failed to provide a federally-mandated Notice of Right to Cancel at the time of closing.

Although it would be interesting to discuss the complications of a rescission almost 3 years after closing (finance charges, closing costs, the prior lien released, etc.), let's instead focus on how to avoid triggering the three-year rescission.

Most importantly, a lender should provide, at closing, two copies of the Notice of Right to Cancel to each homeowner in connection with a covered loan transaction.  What's a covered transaction?

Covered Transaction:  A covered transaction must have the following elements -

1.  Consumer Purpose.  The Truth-in-Lending Act and the Regulation Z govern consumer purpose loans; hence, loans for commercial/business purposes are not covered, even if the collateral securing the loan is the borrower's principal dwelling.  So, the first step is to clearly identify the borrower's intention regarding the loan proceeds.  Business or otherwise?

2.  Principal Dwelling.  The collateral property securing the consumer loan must be the borrower's principal dwelling, which a borrower can have only one at any given time.  Therefore, a consumer transaction secured by the borrower's second home and non owner-occupied investment property is not subject to rescission.

3. Security Interest.  The borrower's right to rescind applies only if the lender takes a security interest in the borrower's principal dwelling.  So, an unsecured loan is not subject to rescission.

Exempt Transactions: As applicable to most mortgage lenders, even if a loan is a covered transaction per the above, the borrower may not have the right to cancel where the loan is a -

1. Residential Mortgage Transaction.

(a) The purpose of the loan is to help the borrower acquire or purchase a principal dwelling.  (Purchase transactions)
(b) The loan proceeds will be used to finance the borrower's initial construction of a principal dwelling. (Interim construction loans for a new primary residence)

2. Refinancing by the Same Lender.  This type of refinancing loans, done by the existing lender, are generally to help reduce a borrower's interest and/or payment.  No new money is advanced in connection with the loan.  

Tricky Situations:  In some consumer loans, it may be tricky to determine whether the loan is a covered or exempt transaction.  For example, the following types of loans in the state of Texas should generally be subject to a federal right of rescission:

• Home Improvement Loans - a lender provides financing for homeowners to repair or renovate their principal dwelling.  Usually, the lender refinances the underlying mechanic's and materialmen's lien that's created in favor of the general contractor, which lien is assigned to the lender as consideration for funding the construction draws.

• Owelty Transactions - a lender provides the financing for a borrower who will use the loan proceeds to pay off co-tenants of a principal dwelling.  Generally, an owelty lien is created in favor of the departing co-tenant, which lien is then assigned at closing to the lender.  The owelty lien underlies the lender's deed of trust lien.

• Home Equity Loans - Loans made by eligible lenders to take equity out of a borrower's principal dwelling.  Numerous requirements apply to home equity loans, and one of which is a state and federal right to cancel the loan.

• Other Refinancing Transactions - Such loans are secured by a lien against a principal dwelling, including, for  example, a rate and term refinance and a tax lien refinance.  (Refinancing by the same lender is an exception.)

Watch Out: North Carolina Fee Limitations on Home Loans

Like many states, North Carolina sets limits on closing fees and charges that a mortgage lender can impose on a borrower in connection with residential mortgage loans.  But North Carolina's fee restrictions are special in a number of ways.

First, on a "home loan" a lender's origination charges are limited to the following:

• loan application, origination, commitment, and interest rate lock fees (HUD-1 801; GFE Box 1);
• bona fide discount points (HUD-1 802; GFE Box 2); and
• additional origination charges (in whatever name) in the aggregate not to exceed the greater of (i) 1/4 of 1% of the note amount, or (ii) $150.  (HUD-1 801; GFE Box 1)  See N.C. Gen. Stat. 24-1.1A(c)(1).

 The net result of the above limitation on a lender's origination charges is simple: other than application fee, origination, commitment fee, rate lock fee, and discount points, a lender can only charge an additional maximum of $150  to cover all other origination fees.  (It's worth noting that the statute does not limit the origination fee (point) to 1% or any particular amount.)  Anything beyond the limit will cause the loan to be out of tolerance.

Second, a "home loan" is defined to mean one where the loan:

• has a principal amount (note amount) that is less than $300,000;
• is a closed-ended transaction; and
• is secured by a first lien against real property with, or to be built upon it, one or more single-family dwellings or dwelling units, or a manufactured home. 

Therefore, the definition is broad enough to cover purchase and refinance transactions to be secured by a principal residence, a second home, or investment property.  But, loans in a subordinate lien position is excluded.

Third, the applicable statute and regulations are silent on the penalties if a lender exceeds the limitation on origination charges.  Usually, it is acceptable under federal law, i.e., RESPA and TILA, to issue a lender credit at the time of closing, or a refund check post closing, to cure any tolerance violations.  When asked whether there is a cure mechanism applicable to a N.C. Gen. Stat. 24-1.1A(c)(1) violation, an employee at the mortgage compliance division of the North Carolina Commissioner of Banks indicated, via informal telephone guidance, that a refund check to the borrower along with a letter of explanation is an acceptable way to cure the violation.  Good record-keeping by a lender is advised in connection with discovering and curing a tolerance violation.