Can we waive a bona fide third-party fee on a home equity loan (that is not a line of credit) and then recoup the fee if the borrower pays off the loan in thirty-six months or less? Is this something we would indicate in the note? We do not believe this would be a prepayment penalty. However, when Regulation Z states that “[a] creditor must not offer a consumer a covered transaction with a prepayment penalty unless the creditor also offers the consumer an alternative covered transaction without a prepayment penalty” — what does that mean? Would an alternative covered transaction be the same loan product with a higher price?

We believe you may recoup bona fide third-party charges that were waived at consummation if the borrower repays the loan within thirty-six months — provided such terms are included in your note — and this recoupment would not be a prepayment penalty. Additionally, if you were to impose a prepayment penalty, we believe you would be required to offer an alternative transaction without a prepayment penalty that is similar to the covered transaction with the prepayment penalty, which may include a higher price, among other criteria for the alternative transaction.

You are correct that recouping bona fide third-party charges would not be considered a prepayment penalty under federal or Illinois law. Under Regulation Z’s “high-cost” mortgage rules, a prepayment penalty is one of three triggers that could cause a loan to be considered “high-cost.” However, for closed-end loans, a “bona fide third-party charge that a creditor imposes if the consumer prepays all of the transaction’s principal sooner than 36 months after consummation” is not considered a prepayment penalty, and such charges would not trigger Regulation Z’s “high-cost” loan provisions. Of course, such an arrangement should be included in the terms of the note (as suggested in the Official Interpretations for Regulation Z).

Similarly, the Illinois High Risk Home Loan Act (HRHLA) excludes a “bona fide third-party charge that the creditor imposes if the consumer prepays all of the transaction’s principal sooner than 36 months after consummation” as a prepayment penalty that would trigger the HRHLA’s provisions.

However, if you were offering a consumer a dwelling-secured credit transaction (a “covered transaction”) with a prepayment penalty, Regulation Z would require you to provide the consumer with an alternative covered transaction without a prepayment penalty. The alternative covered transaction must: (1) have an annual percentage rate that will not increase after consummation and has the same type of interest rate (i.e. fixed-rate or step-rate) as the covered transaction with a prepayment penalty, (2) have the same loan term as the covered transaction with the prepayment penalty, (3) provide for regular periodic payments that are substantially equal, (4) have points and fees that do not exceed the points and fees allowed for qualified mortgage loans, and (5) be a transaction for which the creditor has a good faith belief the consumer will likely qualify.

The CFPB’s Small Entity Compliance Guide on the Ability-to-Repay and Qualified Mortgage Rule provides that “[t]he alternative loan must be similar to the loan with the prepayment penalty, so the consumer can choose between two products he will likely qualify for.” Accordingly, we believe an alternative covered transaction without a prepayment penalty should be similar to the covered transaction with a prepayment penalty, and it may have a higher price than the covered transaction with a prepayment penalty — provided that it meets the other criteria discussed above.

For resources related to our guidance, please see:

Regulation Z, 12 CFR 1026.32(a)(1)(iii) (“The requirements of this section apply to a high-cost mortgage, which is any consumer credit transaction that is secured by the consumer's principal dwelling, other than as provided in paragraph (a)(2) of this section, and in which: . . . Under the terms of the loan contract or open-end credit agreement, the creditor can charge a prepayment penalty, as defined in paragraph (b)(6) of this section, more than 36 months after consummation or account opening, or prepayment penalties that can exceed, in total, more than 2 percent of the amount prepaid.”)

Regulation Z, 12 CFR 1026.32(b)(6)(i) (“For a closed-end credit transaction, prepayment penalty means a charge imposed for paying all or part of the transaction’s principal before the date on which the principal is due, other than a waived, bona fide third-party charge that the creditor imposes if the consumer prepays all of the transaction’s principal sooner than 36 months after consummation . . . .”)

Illinois High Risk Home Loan Act, 815 ILCS 137/10 (“‘High risk home loan’ means a consumer credit transaction, other than a reverse mortgage, that is secured by the consumer’s principal dwelling if: . . . (ii) the loan documents permit the creditor to charge or collect prepayment fees or penalties more than 36 months after the transaction closing or such fees exceed, in the aggregate, more than 2% of the amount prepaid, or . . . .”)

Illinois High Risk Home Loan Act, 815 ILCS 137/10 (“‘Prepayment penalty’ and ‘prepayment fees or penalties’ mean: (i) for a closed-end credit transaction, a charge imposed for paying all or part of the transaction’s principal before the date on which the principal is due, other than a waived, bona fide third-party charge that the creditor imposes if the consumer prepays all of the transaction’s principal sooner than 36 months after consummation . . . .”)

Regulation Z, Official Interpretations, Paragraph 32(b)(6)(i), Comment 1(ii) (“For purposes of § 1026.32(b)(6)(i), the following are examples of prepayment penalties: . . . A fee, such as an origination or other loan closing cost, that is waived by the creditor on the condition that the consumer does not prepay the loan. However, the term prepayment penalty does not include a waived bona fide third-party charge imposed by the creditor if the consumer pays all of a covered transaction's principal before the date on which the principal is due sooner than 36 months after consummation. For example, assume that at consummation, the creditor waives $3,000 in closing costs to cover bona fide third-party charges but the terms of the loan agreement provide that the creditor may recoup the $3,000 in waived charges if the consumer repays the entire loan balance sooner than 36 months after consummation. The $3,000 charge is not a prepayment penalty. . . .”)

Regulation Z, 12 CFR 1026.43(b)(1) (“Covered transaction means a consumer credit transaction that is secured by a dwelling, as defined in § 1026.2(a)(19), including any real property attached to a dwelling, other than a transaction exempt from coverage under paragraph (a) of this section.”)

Regulation Z, 12 CFR 1026.43(g)(3) (“A creditor must not offer a consumer a covered transaction with a prepayment penalty unless the creditor also offers the consumer an alternative covered transaction without a prepayment penalty and the alternative covered transaction:

(i) Has an annual percentage rate that cannot increase after consummation and has the same type of interest rate as the covered transaction with a prepayment penalty; for purposes of this paragraph (g), the term ‘type of interest rate’ refers to whether a transaction: (A) Is a fixed-rate mortgage, as defined in § 1026.18(s)(7)(iii); or (B) Is a step-rate mortgage, as defined in § 1026.18(s)(7)(ii);

(ii) Has the same loan term as the loan term for the covered transaction with a prepayment penalty;

(iii) Satisfies the periodic payment conditions under paragraph (e)(2)(i) of this section;

(iv) Satisfies the points and fees conditions under paragraph (e)(2)(iii) of this section, based on the information known to the creditor at the time the transaction is offered; and

(v) Is a transaction for which the creditor has a good faith belief that the consumer likely qualifies, based on the information known to the creditor at the time the creditor offers the covered transaction without a prepayment penalty.”)

Regulation Z, 12 CFR 1026.43(e)(2)(i) (“Except as provided in paragraph (e)(4), (e)(5), (e)(6), or (f) of this section, a qualified mortgage is a covered transaction: That provides for regular periodic payments that are substantially equal, except for the effect that any interest rate change after consummation has on the payment in the case of an adjustable-rate or step-rate mortgage, that do not: (A) Result in an increase of the principal balance; (B) Allow the consumer to defer repayment of principal, except as provided in paragraph (f) of this section; or (C) Result in a balloon payment, as defined in § 1026.18(s)(5)(i), except as provided in paragraph (f) of this section; . . .”)

Regulation Z, 12 CFR 1026.43(e)(2)(iii) (“Except as provided in paragraph (e)(4), (e)(5), (e)(6), or (f) of this section, a qualified mortgage is a covered transaction: . . . For which the total points and fees payable in connection with the loan do not exceed the amounts specified in paragraph (e)(3) of this section; . . .”)

Regulation Z, 12 CFR 1026.43(e)(3) (“Except as provided in paragraph (e)(3)(iii) of this section, a covered transaction is not a qualified mortgage unless the transaction's total points and fees, as defined in § 1026.32(b)(1), do not exceed: . . .”)

CFPB Small Entity Compliance Guide, Ability-to-Repay and Qualified Mortgage Rule, page 49 (November 3, 2014) (“If you wish to charge a prepayment fee, you must also offer the consumer an alternative transaction that you believe the consumer will qualify for. The alternative loan cannot have a prepayment penalty. The alternative loan must be similar to the loan with the prepayment penalty, so the consumer can choose between two products he will likely qualify for.”)