While it may be possible to avoid Regulation Z’s ability-to-repay (ATR) requirements when making an initial temporary (“bridge”) loan and subsequently modifying it with a term longer than twelve months, we recommend proceeding with caution. The modification of the bridge loan into a balloon loan must be structured carefully to not be considered a “refinancing,” which will subject the transaction to the ATR requirements; meanwhile, your bank must avoid making any representations or establishing any understandings with the customer that the initial bridge loan will be modified into a longer-term balloon loan.

Generally, the conversion of a HELOC after maturity into a closed-end loan is a refinancing, requiring an ATR analysis and closed-end disclosures. However, the ATR requirements do not apply to a new bridge loan that has a term of twelve months or less — even if the bridge loan is renewable, provided the loan agreement states that “any renewal possible under the loan contract is for one year or less.” However, it is unclear whether a loan agreement that has a term of twelve months or less but is silent as to future renewals would cause subsequent renewals to be considered refinancings subject to an ATR analysis.

We asked an attorney from the CFPB whether such a bridge loan (with the terms silent as to renewal periods) can be modified by agreement of the parties for a term longer than twelve months without triggering an ATR analysis. The CFPB attorney said that would depend on whether the renewal is a “refinancing” under Regulation Z, which is a question determined by the parties’ contract and applicable state law.

Importantly, the CFPB attorney cautioned that if at the time the bridge loan is extended, there are any oral agreements or understandings between the parties that the bridge loan will be renewed upon maturity for a term longer than twelve months, then it would not qualify for an exemption from the ATR rule (because a renewal of more than one year would be possible under agreed terms). The CFPB attorney pointed out that this is a fact-based inquiry that is dependent on state law and recommended looking into a number of state law concepts, including the parol evidence rule and the concept of oral agreements being integrated into legal obligations. Their advice is that if a bank wants to take this approach, it should speak to an attorney proficient in legal contract formation under local law, particularly in the area of mortgage loans.

The consequences of failing to perform the required ATR analysis under the Truth in Lending Act are dire. If the customer defaults on the loan and your bank initiates a foreclosure, the customer may raise as a defense your bank’s failure to perform an ATR analysis. The customer may claim that since there was an understanding between the parties that the bridge loan was renewable for a term of more than one year, the bridge loan did not meet the ATR exemption, and an ATR analysis should have been conducted. If a court agrees with this argument, your bank not only could lose the foreclosure action but also could be subject to statutory damages in an amount equal to the customer’s finance charges, fees, and attorney costs.  

For resources related to our guidance, please see:

• Regulation Z, Official Interpretations, Paragraph 40, Comment 2 (“Section 1026.9(c) applies if, by written agreement under § 1026.40(f)(3)(iii), a creditor changes the terms of a home equity plan — entered into on or after November 7, 1989 — at or before its scheduled expiration, for example, by renewing a plan on different terms. A new plan results, however, if the plan is renewed (with or without changes to the terms) after the scheduled expiration. The new plan is subject to all open-end credit rules, including §§ 1026.6, 1026.15, and 1026.40.”)

• Regulation Z, 12 CFR 1026.43(a)(3)(ii) (“This section applies to any 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: . . . For purposes of paragraphs (c) through (f) of this section: . . . A temporary or ‘bridge’ loan with a term of 12 months or less, such as a loan to finance the purchase of a new dwelling where the consumer plans to sell a current dwelling within 12 months or a loan to finance the initial construction of a dwelling; . . .”)

• Regulation Z, Official Interpretations, 12 CFR 1026, Paragraph 43(a)(3), Comment 1 (“Under § 1026.43(a)(3)(ii), a temporary or ‘bridge’ loan with a term of 12 months or less is exempt from § 1026.43(c) through (f). Examples of such a loan are a loan to finance the purchase of a new dwelling where the consumer plans to sell a current dwelling within 12 months and a loan to finance the initial construction of a dwelling. Where a temporary or ‘bridge loan’ is renewable, the loan term does not include any additional period of time that could result from a renewal provision provided that any renewal possible under the loan contract is for one year or less. For example, if a construction loan has an initial loan term of 12 months but is renewable for another 12-month loan term, the loan is exempt from § 1026.43(c) through (f) because the initial loan term is 12 months.”)

• Regulation Z, 12 CFR 1026.20(a) (“A refinancing occurs when an existing obligation that was subject to this subpart is satisfied and replaced by a new obligation undertaken by the same consumer. A refinancing is a new transaction requiring new disclosures to the consumer. . . .”)

• Regulation Z, Official Interpretations, Paragraph 20(a), Comment 1 (“A refinancing is a new transaction requiring a complete new set of disclosures. Whether a refinancing has occurred is determined by reference to whether the original obligation has been satisfied or extinguished and replaced by a new obligation, based on the parties' contract and applicable law. . . . In any form, the new obligation must completely replace the prior one. . . . A substitution of agreements that meets the refinancing definition will require new disclosures, even if the substitution does not substantially alter the prior credit terms.”)

• Truth in Lending Act, 15 USC 1640(k)(1) (“Notwithstanding any other provision of law, when a creditor, assignee, or other holder of a residential mortgage loan or anyone acting on behalf of such creditor, assignee, or holder, initiates a judicial or nonjudicial foreclosure of the residential mortgage loan, or any other action to collect the debt in connection with such loan, a consumer may assert a violation by a creditor of paragraph (1) or (2) of section 1639b(c) of this title, or of section 1639c(a) of this title, as a matter of defense by recoupment or set off without regard for the time limit on a private action for damages under subsection (e).”)

• Truth in Lending Act, 15 USC 1640(2)(a) (“The amount of recoupment or set-off under paragraph (1) shall equal the amount to which the consumer would be entitled under subsection (a) for damages for a valid claim brought in an original action against the creditor, plus the costs to the consumer of the action, including a reasonable attorney’s fee.”)

• Truth in Lending Act, 15 USC 1639c(a)(1) (“In accordance with regulations prescribed by the Bureau, no creditor may make a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan, according to its terms, and all applicable taxes, insurance (including mortgage guarantee insurance), and assessments.”)

• Truth in Lending Act, 15 USC 1640(a)(4) (“Except as otherwise provided in this section, any creditor who fails to comply with any requirement imposed under this part, . . . with respect to any person is liable to such person in an amount equal to the sum of . . . (4) in the case of a failure to comply with any requirement under section 1639 of this title, paragraph (1) or (2) of section 1639b(c) of this title, or section 1639c(a) of this title, an amount equal to the sum of all finance charges and fees paid by the consumer, unless the creditor demonstrates that the failure to comply is not material.”)