Our residential construction loan agreements permit us to charge a fee if the customer does not choose to obtain permanent financing with our institution. The loans are secured by the borrower’s principal dwelling. Can we charge this type of fee?

Yes, from what you have told us, we believe you may charge this fee. We are not aware of any law that would prohibit such a contingent fee for a short term construction loan, assuming that the loan is not subject to Illinois’ High Risk Home Loan Act (HRHLA), as discussed below.

Unlike Regulation Z, which exempts construction loans from its “high cost mortgage” provisions, the HRHLA does not exempt construction loans. The HRHLA has three triggers that would subject a residential construction loan to its provisions:

(i) Interest rate trigger. An APR that exceeds the average prime offer rate by more than 6% in the case of a first lien mortgage, or by more than 8% in the case of a junior mortgage.

(ii) Points and fees trigger. Total points and fees that exceed 5% of the loan amount for a transaction of $20,000 or more, or the lesser of 8% of the total loan amount or $1,000 for a transaction under $20,000 (but note that both the $20,000 and $1,000 figures are tied to the CFPB’s annual inflation adjustments – for 2015, the amounts are $20,391 and $1,020, respectively).

(iii) Prepayment penalty trigger. A prepayment penalty that either exceeds 2% of the amount prepaid or is imposed more than three years after the loan’s consummation.

If either of the first two triggers applies to a residential loan, the HRHLA outright prohibits a prepayment penalty imposed in any amount at any time. If a prepayment penalty is not otherwise prohibited, it must remain below the third trigger’s thresholds.

Assuming that your construction loan is below the thresholds for the interest rate and points and fees triggers, the question is whether the contingent fee imposed for not refinancing with your bank could be considered a prepayment penalty. The HRHLA defines a “prepayment penalty” as “a charge imposed for paying all or part of the transaction’s principal before the date on which the principal is due.” We believe there is a strong argument that the contingent fee you are describing should not be treated as a prepayment penalty, since it is not charged for prepayment of the loan, but rather for payment of the loan at the end of the loan term (on the date on which the principal is due), albeit it only when a certain condition (refinancing with your bank) is not met.

However, we cannot entirely discount the possibility that your examiners or a borrower might try to argue that the contingent fee should be treated as a prepayment penalty, simply because it “penalizes” the borrower when a decision is made to refinance with another lender. If the contingent fee were to be found to be a prepayment penalty, and it exceeds 2% of the amount paid off or could be charged more than three years after the loan closing, the HRHLA would prohibit the contingent fee, regardless of whether it actually is imposed. In addition, if imposing the contingent fee would cause the loan to exceed the points and fees trigger, this also would result in the fee being prohibited, irrespective of whether it is imposed.

Because this question is one of first impression under the HRHLA, you may wish to consult with your bank counsel or the IDFPR’s Division of Banking regarding our interpretation of the law. In any event, should you choose to take the position that the contingent fee is not a prepayment penalty, make sure that the language in your loan documentation is very precise regarding the point that payment of the fee is due on the date on which the principal is due, and not earlier.

For resources related to our guidance, please see:

High Risk Home Loan Act, 815 ILCS 137/10, as amended by Public Act 99-288 (Defines a prepayment penalty as “(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 . . . (ii) for an open-end credit plan, a charge imposed by the creditor if the consumer terminates the open-end credit plan prior to the end of its term . . . .”)

High Risk Home Loan Act, 815 ILCS 137/10, as amended by P.A. 98-288 (Defines a high risk home loan as “a consumer credit transaction 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 (iii) the total points and fees payable in connection with the transaction, other than bona fide third-party charges not retained by the mortgage originator, creditor, or an affiliate of the mortgage originator or creditor, will exceed (1) 5% of the total loan amount in the case of a transaction for $20,000 (or such other dollar amount as prescribed by federal regulation pursuant to the federal Dodd-Frank Act) or more or (2) the lesser of 8% of the total loan amount or $1,000 (or such other dollar amount as prescribed by federal regulation pursuant to the federal Dodd-Frank Act) in the case of a transaction for less than $20,000 (or such other dollar amount as prescribed by federal regulation pursuant to the federal Dodd-Frank Act), except that, with respect to all transactions, bona fide loan discount points may be excluded as provided for in Section 35 of this Act.”)

High Risk Home Loan Act, 815 ILCS 137/30 (“A high risk home loan may not contain terms under which a consumer must pay a prepayment penalty for paying all or part of the principal before the date on which the principal is due.”)