We have a customer who applied for a home equity loan secured by a first lien. Our mortgage system alerted us that the loan is a higher-priced mortgage loan (HPML). We are aware that under Regulation Z, a lender may not extend an HPML unless an escrow account is established for the payment of property taxes and insurance, and the escrow account must be maintained for at least five years. However, our loan department has advised that under Illinois law the escrow account may be discontinued when the loan balance has been paid down to 65% of the original balance. Does this apply to HPMLs?

No, for HPMLs, federal law generally requires that escrow accounts remain in place for five years, even when Illinois law otherwise would permit the borrower to terminate the escrow account.

You are correct that under Regulation Z, a lender generally cannot extend an HPML secured by a first lien on a consumer’s principal dwelling unless an escrow account is established for property taxes and insurance premiums. The escrow accounts must be maintained for the first five years after the loan consummation unless the underlying debt obligation is terminated. After five years, the escrow accounts may be canceled at the consumer’s request only if the unpaid principal balance is less than 80% of the original value of the mortgaged property and the consumer is not delinquent or in default on the loan.

Your loan department also is correct that Illinois law allows a borrower to terminate an escrow account when the loan has been paid down to 65% of the original principal balance and the borrower is not in default on the loan. However, this law does not supersede federal law if Regulation Z’s requirements for terminating an escrow account for an HPML have not been met. Although some federal laws expressly allow state law to supersede the federal law, no such allowances exist for HPML escrow requirements. Further, we are aware of at least one Illinois court that found that federal escrow regulations which conflict with Illinois law preempt the Illinois law’s requirements.

For resources related to our guidance, please see:

Regulation Z, 12 CFR 1026.35(b)(1) (“Except as provided in paragraph (b)(2) of this section, a creditor may not extend a higher-priced mortgage loan secured by a first lien on a consumer’s principal dwelling unless an escrow account is established before consummation for payment of property taxes and premiums for mortgage-related insurance required by the creditor, such as insurance against loss of or damage to property, or against liability arising out of the ownership or use of the property, or insurance protecting the creditor against the consumer's default or other credit loss. . . .”)
Regulation Z, 12 CFR 1026.35(a)(1) (“‘Higher-priced mortgage loan’ means a closed-end consumer credit transaction secured by the consumer’s principal dwelling with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction as of the date the interest rate is set:

(i) By 1.5 or more percentage points for loans secured by a first lien with a principal obligation at consummation that does not exceed the limit in effect as of the date the transaction's interest rate is set for the maximum principal obligation eligible for purchase by Freddie Mac;

(ii) By 2.5 or more percentage points for loans secured by a first lien with a principal obligation at consummation that exceeds the limit in effect as of the date the transaction's interest rate is set for the maximum principal obligation eligible for purchase by Freddie Mac; . . .”)

Regulation Z, Higher-Priced Mortgage Loan Provisions, 12 CFR 1026.35(b)(3)(i) (“Except as provided in paragraph (b)(3)(ii) of this section, a creditor or servicer may cancel an escrow account required in paragraph (b)(1) of this section only upon the earlier of: (A) Termination of the underlying debt obligation; or (B) Receipt no earlier than five years after consummation of a consumer’s request to cancel the escrow account.”)
Regulation Z, 12 CFR 1026.35(b)(3)(ii) (“Notwithstanding paragraph (b)(3)(i) of this section, a creditor or servicer shall not cancel an escrow account pursuant to a consumer’s request . . . unless the following conditions are satisfied: (A) The unpaid principal balance is less than 80 percent of the original value of the property securing the underlying debt obligation; and (B) The consumer currently is not delinquent or in default on the underlying debt obligation.”)
Mortgage Escrow Account Act, 765 ILCS 910/5 (“When the mortgage is reduced to 65% of its original amount by payments of the borrower, timely made according to the provisions of the loan agreement secured by the mortgage, and the borrower is otherwise not in default on the loan agreement, the mortgage lender must notify the borrower that he may terminate such escrow account or that he may elect to continue it until he requests a termination thereof, or until the mortgage is paid in full, whichever occurs first.”)
Olsen v. Financial Fed. Sav. & Loan Ass'n, 105 Ill. App. 3d 364, 371 (1st Dist. 1982) (“Indeed, as the subject of escrow accounts to secure payment of property taxes on mortgage property is specifically addressed by regulations promulgated by the Board in its exercise of its Congressional mandate to provide for the operation of federal savings and loan associations, this area is preempted . . . and any attempt by a state to regulate which potentially conflicts with federal legislation or regulations or with their purpose or that results in a lack of uniformity in the internal management or lending practices of a federal savings and loan association is subordinated to federal law. . . . Based on the foregoing analysis, we hold that the trial court below properly dismissed the plaintiffs' action based on its finding that the provisions of the Illinois Mortgage Escrow Account Act are not applicable to federal savings and loan associations because of the constitutional doctrine of federal preemption.”)