Our bank made a closed-end construction loan to a borrower. The loan was not intended to convert to permanent financing after construction was complete. However, now that construction is complete, the loan has a remaining balance of $100,000. The loan is up for renewal, and we would like to change the terms from a variable rate to fixed rate and from interest only payments to principal and interest payments. Can we issue a change in terms without issuing a new loan?

Whether a subsequent transaction related to the same loan should be treated as a new loan depends on the specific facts, including consideration of the original and any subsequent loan documents. In this situation, for the reasons discussed below, we believe that the continuation of the extension of credit should be treated as a new loan.

Regulation Z distinguishes a “refinancing” – which is considered a new transaction – from renewals, extensions and modifications, which typically are not considered new transactions. The general rule is that a refinancing occurs only when an existing obligation is “satisfied and replaced” by a new transaction, based on the parties' contract and applicable law.

Renewals are specifically exempt from the definition of “refinancing” when there is no change in the original terms. In this case, you intend to make material changes to the terms of the original construction loan, including the type of interest rate (from variable to fixed) and the type of payments (from interest only to principal and interest). Consequently, we do not think the contemplated transaction would constitute a renewal.

There are a few court decisions that indicate generally how to structure a transaction as a modification as opposed to a refinancing, which are dependent on the specific language in the loan documents. For example, one federal court in Illinois reviewed the language of a modification agreement and determined that it did not constitute a refinancing because the modification agreement specifically stated that it was merely amending and supplementing the original loan agreement and not satisfying or releasing the existing obligation.

However, regardless of the terminology used in the loan documents, here you intend to make significant changes to the original obligation. In our view, where construction is complete and material terms in the original obligation are changed, the lender is converting the construction loan to permanent financing, a situation that requires new disclosures (unless the permanent financing disclosures were made together with the construction loan disclosures at the outset of construction loan).

For resources related to our guidance, please see:

Regulation Z, 12 CFR 1026.20(a) (defines “refinancing” as a transaction where an existing obligation is satisfied and replaced by a new obligation undertaken by the same consumer and in subsection (a)(2) provides that a reduction in the annual percentage rate with a corresponding change in the payment schedule is not a refinancing)

Regulation Z, 12 CFR 1026.20(a)(1) “The following shall not be treated as a refinancing: A renewal of a single payment obligation with no change in the original terms.”)

Rodriguez v. Chase Home Finance, LLC, No. 10 C 05876 (N.D. Ill. Sept. 23, 2011) (analyzing the language of a modification agreement and finding that it was not a refinancing)

In re Sheppard, 299 BR 753, 764 (Bankr. E.D.Penn. 2003) (where a modification agreement stated that it “amends and supplements” the original security agreement, it required the borrower to “comply with all other covenants, agreements, and requirements” from the original security agreement, and it also stated that “[n]othing in this Agreement shall be understood or construed to be a satisfaction or release in whole or in part” of the original security agreement. Relying on those three provisions, the court held that the modification was not a refinance.)

Regulation Z, Official Interpretations, 12 CFR 1026, Paragraph 17(c)(6) Comment 2 (“Section 1026.17(c)(6)(ii) provides a flexible rule for disclosure of construction loans that may be permanently financed. These transactions have 2 distinct phases, similar to 2 separate transactions. The construction loan may be for initial construction or subsequent construction, such as rehabilitation or remodeling. The construction period usually involves several disbursements of funds at times and in amounts that are unknown at the beginning of that period, with the consumer paying only accrued interest until construction is completed. Unless the obligation is paid at that time, the loan then converts to permanent financing in which the loan amount is amortized just as in a standard mortgage transaction. Section 1026.17(c)(6)(ii) permits the creditor to give either one combined disclosure for both the construction financing and the permanent financing, or a separate set of disclosures for the 2 phases. This rule is available whether the consumer is initially obligated to accept construction financing only or is obligated to accept both construction and permanent financing from the outset.”)