Summary:

Questions frequently arise about the distinction between consumer and business purposes when making private money loans secured by real estate.

Understanding the distinction between consumer and business purpose lending is crucial; it's empowering. It equips us with the necessary knowledge to navigate the lending landscape of private money loans secured by real estate confidently, giving us a sense of control and confidence in our decisions.

Article:

Both federal and most state governments have established regulations that require lenders to disclose unique information and report specific responsibilities to borrowers with consumer-purpose loans. These additional requirements carry extreme punitive consequences for any mistakes or deviations made by the lender(s) and the procuring mortgage broker(s). These onerous changes have caused most private money lenders to exit consumer lending altogether.

What is a business-purpose real estate loan?

Business purpose loans are made for 1 to 4 residential units of real property, where the loan proceeds are used primarily for business purposes. Mainly used for business is essential. This means that a portion of the loan proceeds, exceeding 50%, must be used for business purposes. A percentage of the loan proceeds (less than 50%) may be for consumer purposes.

A consumer-purpose loan is one where the proceeds are primarily used for personal, family, or household purposes.

When borrowers search for a loan, they may discover they can only find lenders who make business-purpose loans. They often construct a narrative to justify their loan business. Some constructs are legitimate, such as using the loan to start a business or invest in a property, and some are not, like using the loan for personal expenses. Borrowers seeking a loan for business purposes must provide substantial documentation. Proper documentation, which evidences the business purpose in the broker's file, is necessary and paramount, providing a sense of security and reassurance in our lending practices.

In the event of default, the borrower's memory may become fuzzy about the purpose of the loan. A business-purpose borrower may suddenly become a vulnerable consumer who feels they have been taken advantage of. If the borrower's narrative is deemed illegitimate, it could lead to severe legal and financial consequences for both the borrower and the lender. This is a stark reminder of the importance of proper documentation and transparency in lending, offering reassurance and confidence in our lending practices and showing our borrowers that we trust and respect them.

The history of conversations will quickly turn from I want a business purpose loan to You knew all along that I would use all the proceeds personally, and you told me to do it this way. You also knew that I could not afford the payments. A defaulting borrower may conveniently blame the broker or lender, claiming they were instructed to do so. Commonly, when borrowers default, the big bad wolf mortgage broker is at fault. Blaming others for one's default or problems has become the American way.

The greater the percentage of loan proceeds used for business, the safer it is for the lender and the procuring loan broker in the event of default. What I mean by safer is whether the lender or procuring loan broker could become entangled in the borrower's accusation that the loan was a disguised consumer loan.

The business purpose exemption, a concept not explicitly stated in the Truth in Lending regulations, is a crucial tool for lenders and brokers. This means that certain business-purpose loans are not subject to the same stringent regulations as consumer loans, which provides much-needed flexibility and can significantly impact the lending process.

Most private money lenders and mortgage brokers have shifted their focus from consumer-purpose lending to business lending. Many mortgage brokers have found that consumer-related lending is not worth the risk of legal liability if something goes wrong. Judges and courts are often perceived as being biased toward the less sophisticated consumer/homeowner parties, which refers to consumers who may not fully understand the terms and conditions of their loans.

Businesspersons in U.S. law courts, especially in California, who are suspected of wrongdoing are presumed guilty until proven innocent. Proving innocence can be aggravated by the ideological leanings of the parties. The court system has leftist-leaning, bureaucratic labor union public employees, judges, and judge assistants. Most highly experienced practitioners will agree!

Any accusation of a perceived infraction, such as violating Truth-in-Lending or other state and federal laws, even with little legal basis, could result in significant financial costs for a mortgage broker, including discovery, court, and attorney fees. Their entire career and real estate lending license could be on the line with every consumer loan transaction, highlighting the high stakes.

Here are a few recommendations under the category of best practices:

• A broker should not just consider but also require that the business purpose portion of the net loan proceeds is disbursed in escrow and closed into a business account.
• I'd appreciate it if you could obtain a borrower's resume and a history of their business activities, including the purpose of the business.
• A website or online evidence of a company's presence or a bonified business may be helpful.
• A resume can verify the correlation between the consumer's occupation and redundancy. An investor may repeatedly purchase investment real estate for rehabilitation and resale, potentially generating a profit.
• For speculative vertical construction loans, if the security property is a residential property with 1 to 4 units, the loan file should contain a statement from the borrower stating that they intend to sell the finished property on the open market and that they do not intend to occupy the home as their primary residence.
• Obtain a list of items and dollars to be spent for business-related expenses contemplated by the borrower. Written estimates from vendor cost bids are helpful.

Adhering to a new set of underwriting standards and loan approval considerations is crucial; it provides reassurance, especially for borrowers facing challenges during the COVID-related crisis and the changes in California real estate laws. This ensures a secure and confident lending process, giving you peace of mind and the reassurance that you're operating within the bounds of the law.

Borrowers may need loans secured by their real estate to catch up or strengthen the financial position of their business enterprise(s), maintain good credit status, and return to timely payment habits. Property owners and borrowers may have taken advantage of payment deferrals due to the lack of tenant payments or foreclosure moratoriums resulting from state and federal mandates. In such situations, a fresh start loan is not just an option; it's a necessity.

Lenders and mortgage brokers should obtain a completed borrower's loan application, financial documents, credit report, and an independent third-party appraisal.

The procuring lender can verify the availability of cash flow from the borrower(s), the borrower(s) business, and the subject property for expenses and debt service. Bank statements or tax returns with a profit & and loss report may be helpful. Three to six months of business and personal bank statements are usually adequate for private money loans.

I'd like to point out that conducting a compassionate circumstances analysis is essential for credit considerations and approval. This approach ensures the borrower's ability to repay and fosters empathy and understanding in the lending process.

Many private money lenders are equity-driven rather than income stream-driven. For example, many lenders have historically assumed that if a borrower has a property with a 60% loan-to-value ratio and 40% as protective equity, the lender may not require much more than an application, an independent appraisal, and a credit report. Timely payments and adherence to the loan terms are assumed, as any borrower accumulating that much equity over time is unlikely to default. Somewhere between equity-driven lending and credit and income-driven lending lies the answer. We may find that loan-to-value and analysis methods will change in response to recently passed laws and new legislation pending.

Consumer purpose laws are purpose-driven by borrowed funds, not property collateral-driven.

It is natural to confuse owner occupancy and consumer protection with whether the Federal Truth in Lending Act (TILA) covers a loan. Loans do not have to be owner-occupied to comply with the Truth in Lending and ability-to-repay requirements. RESPA (Real Estate Settlement Procedures Act), Dodd-Frank, and other federal and state regulatory requirements are also involved.

Suppose a gas station owner who rents out his property to a third party borrows money using the gas station as collateral to consolidate personal, family, and household debts and to improve his owner-occupied home. In that case, it is a consumer loan.

Loan transactions should be closed by a licensed escrow company, and a title insurance policy should be provided. Escrow agents have a dual fiduciary between a buyer/seller and a borrower/lender. The lender or mortgage broker manages the regulatory compliance issues and underwriting, but escrow and title handle the escrow instructions, settlement procedures, and closing statements. Borrowers and lenders must read the title insurance policy's narrative escrow instructions, coverages, exceptions, and exclusions. Exceptions and exclusions refer to items not covered by the title insurance policy.

AB 3108, the new law passed by the California Legislature and signed by Governor Newson, casts some extremely cloudy skies over the lending business. It creates further prohibitions, enhances liabilities, and invites borrowers to sue brokers for fraud and negligent misrepresentation.

AB 3108 codifies a new violation of the Penal Code for specified actions or conduct by real estate or mortgage brokers. This legislative measure would prohibit filing any document with the county's recorder that the person knows contains a material misstatement, misrepresentation, or omission. See Financial Code Section 4973 et seq and Penal Code Section 532f; Seeley v. Seymour (1987)190 Cal App 3rd 84.

AB 3108 adds criminal penalties to existing administrative discipline, civil actions, and other criminal sanctions for industry violations of the California Real Estate and Securities Laws and other applicable federal and state laws. The inappropriate actions or conduct of real estate or mortgage brokers typically represent negligence, incompetence, fraud, and dishonesty.

Administrative remedies for violations of Real Estate Law and other statutes and regulations may include license discipline, revocation of registrations, charters, or permits, and the possibility of the licensee being subject to a Bar Order prohibiting engagement in Real Estate, Mortgage, or Related Industries for a specified period.

Remedies for civil complaints involving inappropriate actions or conduct may include imposing damages for losses incurred by the licensee's principals in real property and real property secured transactions, as well as potentially significant punitive damages. Material misrepresentations by licensees, including inflating broker price opinions; making false and misleading statements of material facts (e.g., promising unrealistic or unsupported returns on investments); omissions of material facts; offering half-truths as well as the failure to disclose property defects (known, or should have been known) are illustrations of inappropriate actions/conducts.

Inappropriate actions or conduct and failure to adhere to industry standards for best practices are typically breaches of fiduciary duties owed to principals in real property or real property-secured transactions. Such licenses are performing beneath their standard of care.

The concern is whether this expansion to criminalize the actions and conduct of real estate and mortgage brokers under AB 3108 could inadvertently lead to criminalizing individual citizens' political statements and representations. The conflicts among individuals or groups regarding current political, economic, legal, and governmental standards and objectives for our nation-state underscore the need to consider, when enacting such legislation, its impact on society, historical culture, institutions, the rule of law, and the U.S. Constitution.

Various observers have expressed concern about the potential for runaway and expensive litigation involving licensees being charged for alleged and potentially vague violations of AB 3108. It has been suggested that video and/or audio recordings should memorialize the presentation and review of future written and oral communications between real estate/mortgage brokers and their clients and customers.

Concern also extends to bringing costly and inappropriate actions against citizens for public policy statements that have historically been protected by Free Speech, as promised by the First Amendment. Some such statements are perceived as misinformation or disinformation by particular elected or appointed government officials, bureaucrats representing government agencies, departments, offices, representatives of private institutions, or other NGO personnel or entities.

For the technically minded?

Most state and federal laws related to loans secured by 1 to 4-unit residential dwellings apply only to consumer-purpose real estate loans.   Consumer-purpose loans are those where the proceeds are primarily used for personal, family, or household purposes.  Individual (s) and family trust are considered consumers.

Entities like corporations or limited liability companies are not considered consumers.

Regulation Z was a Federal Reserve Board regulation that implemented the Truth in Lending Act (TILA) of 1968. Reg Z was all part of the Consumer Credit Protection Act of 1968. The act's primary goal was to provide consumers with better information and disclosures about the actual cost of credit, including calculating the annual percentage rate (APR). An APR calculation includes all borrowing costs, with interest rates and fees. Lenders must disclose interest rates in writing, allow borrowers to cancel (within a 3-day right of rescission), and provide written disclosures about the loan terms and costs.

My comments and opinions are not all-encompassing. Consumer and business purpose lending is made more complex by state and federal government regulations that sometimes conflict. Any owner, borrower, lender, or mortgage broker should consult a highly competent lawyer to guide them in appropriate actions.