Part 1 of 2 – Federal factors.
Although lenders are perhaps more familiar with the regulations involved in making loans to consumers, it is important to keep in mind that different rules apply to business purpose loans secured by real property. The first step in the analysis is, naturally, to determine whether the loan is a business purpose loan, or a consumer purpose loan.
In Part 2, we will examine some of the state considerations. Part 1 we focus on some of the federal considerations, starting with the Truth in Lending Act (TILA). Along with its federal implementing regulations, TILA imposes a number of significant compliance and disclosure obligations on mortgage lenders. If a loan is exempt from the coverage of TILA, then these requirements will not apply.
Two principal TILA exemptions are potentially applicable in these situations. First, if the loan is extended to an entity (i.e. a non-natural person), as opposed to an individual, then TILA will not apply. Second, loans made primarily for business or commercial purposes are also exempt.
The Official Commentary to Regulation Z, which is TILA’s implementing regulation, sets forth guidelines for determining whether a loan can be considered to be primarily for a business purpose. To make that “business purpose” determination, a creditor should evaluate five factors:
1) The relationship of the borrower’s primary occupation to the acquisition. The more closely related, the more likely it is to be business purpose.
2) The degree to which the borrower will personally manage the acquisition. The more personal involvement there is, the more likely it is to be business purpose.
3) The ratio of income from the acquisition to the total income of the borrower. The higher the ratio, the more likely it is to be business purpose.
4) The size of the transaction. The larger the transaction, the more likely it is to be business purpose.
5) The borrower’s statement of purpose for the loan. Naturally, the borrower’s stated purpose for the loan will indicate whether it is for a business purpose.
These factors are useful in circumstances where it may not be clear whether the loan has a business purpose, or a consumer purpose.
Examples of business purpose loans include:
- A loan to expand a business, even if it is secured by the borrower’s residence or personal property. The expansion of business is the purpose of the loan.
- A loan to improve a principal residence by putting in a business office. The business office, though placed in a residence, is the purpose of the loan.
- A business account used occasionally for consumer purposes. While the account may have a mixed use, the fact that is a business account means it is a business purpose loan.
Examples of consumer purpose loans include:
- Credit extensions by a company to its employee or agents if the loans are used for personal purposes.
- A loan secured by a mechanic’s tools to pay a child’s tuition. The payment of tuition is a consumer purpose.
- A personal account used occasionally for business purposes. The personal nature of the account means it is a consumer purpose loan.
See, Official Commentary, 12 C.F.R § 1026.3.
In determining the primary purpose of a loan (business or consumer), the focus of the inquiry is not on the nature of the property securing the loan, but rather on the borrower’s motive for obtaining the loan. Importantly, determining the true business purpose of a loan is the responsibility of the lender. Lenders must build policies and procedures designed to sufficiently determine the true purpose of a loan and should provide on-going training to its employees on those policies and procedures. Lenders making business-purpose loans should also be mindful of their federal and state compliance obligations, and should have appropriate policies and procedures in place to address these requirements. Lastly, Lenders should document the business purpose of the loan with the borrower.