With the recent changes to the Home Mortgage Disclosure Act (HMDA) which became effective on January 1, 2018, many compliance professionals have had to rethink how they report certain loan situations for HMDA purposes. Particularly, there have been some logistical challenges in the way certain Home Improvement loans are reported.
Understanding HMDA Rules for Home Improvement Loans
Under the old HMDA rules, a multi-purpose loan that was both a home improvement loan and a refinancing would have been reported as a home improvement loan. In 2018, however, that hierarchy changed where that a refinancing now takes precedence over a home improvement purpose. Due to this change, many HMDA reporters have had to rethink how they report certain types of home improvement loans.
The Home Improvement Question
Over the years, HMDA reporters have struggled to know how to report an end loan that replaced a temporary loan that was clearly for the purpose of home improvement. Specifically, there have been two scenarios that have generated a question of how to report the end loan that replaced a temporary loan with the purpose of Home Improvement.
- Scenario 1: A lender grants a customer a temporary loan that satisfies and replaces an existing loan to the same borrower, and has the purpose of a home improvement loan. The temporary loan is then paid off by permanent financing.
- Scenario 2: A customer owns their home free and clear and requests a loan to take the equity out of their home for the purpose of home improvement. The lender grants the customer a temporary loan for the home improvement and then also grants an additional, permanent loan to pay off the temporary loan.
The question on both of these scenarios is this: Should the end loan be reported as having a purpose of a home improvement or a refinance?
Home Improvement Under Old HMDA Rules
The debate on how to report the end loan when an initial temporary loan is for the purpose of Home Improvement has been a topic of debate for years, even under the old rules. The reason this topic has been debated is that there are two schools of thought, or camps, in regards to how to report the end loan. One camp believes that an end loan should be reported as a Home Improvement loan as this was the purpose of the original request. The other camp believes that the end loan should be reported as a refinance as the end loan does, in fact, satisfy and replace an existing loan to the same borrower - the temporary loan.
Now, under the old rules, things were less complicated than they are today under the new rules. We will get into this in more detail later, but the bottom line is that the old rules were simpler because a home improvement purpose trumped a purpose of a refinance under the old HDMA hierarchy. This means that both scenario 1 and scenario 2 (as described above) were treated the same way, regardless of what “camp” was chosen. Unfortunately, the rules become a bit more complicated under the new HMDA rules that went into effect in 2018.
Home Improvement Purpose Under New HMDA Rules
The HMDA changes that went into effect on January 1, 2018, have made things more complicated in regards to an end loan where the initial purpose of a temporary loan that is being satisfied and replaced by the end loan had a purpose of home improvement. Specifically, the new hierarchy - where a refinance now trumps a home improvement purpose - has made consistency more challenging as reporting would now be different in Scenarios 1 & 2 (as described previously). Let me explain.
Scenario 1 occurs when a lender grants a customer a temporary loan that satisfies and replaces an existing loan to the same borrower, but also has the purpose of a home improvement loan. The temporary loan is then paid off by permanent financing. In this case, it is important to note that the purpose of refinance takes priority over the home improvement purpose. This means, for all intents and purposes, that the purpose of the temporary loan (which is not reportable) is for the purpose of a refinance. Therefore, there should be no doubt that the end loan that pays off (satisfies and replaces) the temporary loan should be reported as a refinance. To me, this is now extremely clear due to the new purpose hierarchy.
That said, things get a bit more complicated under the next scenario. Scenario 2 occurs when a customer owns a home free and clear and requests a loan to take out equity for the purpose of home improvement. The lender grants the customer a temporary loan for the home improvement and then also grants an additional, permanent loan to pay off the temporary loan. In this case, the temporary loan, for all intents and purposes, would be a home improvement loan (if it was actually HMDA reportable). The question then moves to the end loan that satisfies and replaces the temporary loan: Should the end loan be reported as having a HMDA purpose of home improvement, a refinance, or a cash-out refinance?
Three Different Camps for Reporting Home Improvement Loans
Essentially, there are three different schools of thought regarding how to report the end financing that replaces a temporary loan that would have been for the purpose of home improvement (meaning the temporary loan was not satisfying and replacing an existing loan). These three different schools of thought can be referred to as “camps” and are understood as follows.
Camp 1: Report the Permanent Loan as a Home Improvement
The idea behind this camp is that the customer’s initial request was for a purpose of Home Improvement, so a lender should report that purpose regardless of how they actually structured the funds for them. Basically, the thought is that it was the financial institution’s choice to do the transaction as two seperate loans, meaning that the customer had one single request: to borrow money for the purpose of home improvement. This camp also follows the logic in HMDA that requires a financial institution to report the permanent loan that replaces a temporary construction loan (new build) as a purchase. Basically, the logic is that since HMDA rules specifically require the initial purpose to be reported on the end loan (that replaces the temporary loan), then loans for a purpose of home improvement should also follow this approach. The bottom line for this camp is that the purpose of the loan is for Home Improvement regardless of how the bank decided to structure the loan(s).
Camp 2: Report the End Loan as a Refinance
This camp believes that the end loan which replaces a temporary loan (that would have been for a Home Improvement Purpose) should be reported as a refinance. They base their argument on two main points. First, HMDA rules never actually say to list an end loan as a HI loan when that loan itself is not truly for a purpose of home improvement. While HMDA rules do provide for an exception to report an end loan that replaces an initial construction loan as a purchase, this guidance is an exception to the rule. The thought is that if the rulemakers wanted home improvement loans reported this way, there would have been a similar provision specific to home improvement loans. This camp believes that since the rules do not provide an exception for this scenario, the “logic” from the purchase situation cannot be used.
In addition to the “lack of logic” argument, this also camp points out that the end loan in this scenario is a refinance by definition, which trumps the purpose of a home improvement under the new rules. The point here is that the rulemakers placed a greater value on reporting refinancings than on reporting home improvement loans under the new rules. In fact, the preamble to the final HMDA rules explain how there is now a greater concern about refinancings than there is about home improvement loans. For example, the commentary states the following:
Although home improvement data was a central concern when HMDA was originally enacted, it may be the case that these data are no longer useful. While consumers routinely resorted to local banks for home improvement loans in the 1970s, after the widespread adoption of credit cards began in the 1980s consumers had alternative means of obtaining credit to repair or improve their homes. This trend may have accelerated during the 1980s and early 1990s, when home-equity lines of credit became an increasingly popular form of credit. In today's market, statistics suggest that HMDA provides the public with relatively little data about home improvement loans. (Note: Those of you who are HMDA geeks can read more about the CFPB’s reasoning here: https://www.compliancecohort.com/blog/new-hmda-hierarchy)
The bottom line for Camp 2 is to report the end loan as a refinancing as that loan does, in fact, satisfy and replace an existing loan to the same borrower.
Camp 3: Report the Permanent Loan as a Cash-Out Refinance
I hadn’t really thought about a third camp until writing this article as I have not had question referencing camp 3 asked before, but I now realize there could be a third camp that is essentially a hybrid of boths camps 1 and 2. In short, this camp would take an approach that since equity was tapped into during the loan process, that this should be recognized with the HMDA reporting. The idea is that since a purchase trumps a home improvement loan (following camp 2), it must be reported in the refinance family. However, since the full loan transaction (including the intitial loan) provided funds to the borrower, then the final loan should be reported as a cash-out refinance.
Honestly, I don’t think that this approach provides as much as an argument as Camps 1 and 2, but I could see where someone might question taking this approach.
Choosing a Camp
At the end of the day, your financial institution is going to have to choose a camp on how you report the end loan that satisfies and replaces a temporary loan that was for the purpose of home improvement.
Personally, I have been in Camp 2 all along, even prior to the 2018 HMDA changes. In fact, my reasoning goes beyond that of the argument laid out in Camp 2. The bottom line for me is that I believe that Camp 2 is just easier to manage logistically than camps 1 or 3. I have seen where financial institutions attempt to follow Camp 1 but end up having a very difficult time tracking the home improvement loan to the end loan - meaning that they are inconsistent in how they report one loan to the next. Basically, I just think it is easier to manage when you report Scenario 2 as a refinance. Furthermore, if the temporary loan is satisfying and replacing an existing obligation, there is no debate that those loans should be a refi. Therefore, if you are reporting free and clear loans as being home improvement but reporting those that were not free and clear as a refinance, you will have have different requirements for different situations, which will make things very confusing for your lenders (and you). Again, it is my opinion that it is just easier to report it end loans that replace a temporary loan (that otherwise would have had the purchase of home improvement) as having a purpose of a refinance.
All of that said, it is important to recognize that this is, in fact, a gray area. Therefore, as long as you are being consistent and can argue effectively with an examiner, you should be fine regardless of which camp you are in.
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