Lending 101

A Finance Charge Tutorial

If you work in the consumer lending area, you probably know that the Reg Z "finance charge" disclosure contains some troublesome provisions that can stump even an experienced lender. That's because the definition of what is a "finance charge" often varies depending on the type of loan being made. For example, a particular fee might be a finance charge in a car loan, but not a finance charge in a real estate loan.

Although the rules are not cut and dried, it's important that you disclose the finance charge accurately. Because the finance charge is intended to show borrowers the actual cost of credit, it is often used by borrowers for comparison shopping purposes.  Also, examiners often focus on the finance charge disclosure, since an incorrect finance charge is a Reg Z violation and likely means the annual percentage rate (APR) is wrong, too. Because borrowers and examiners expect an accurate finance charge disclosure, its important to have a clear understanding of how the term is defined in Reg Z.

What is a "finance charge?"

According to Reg Z, a finance charge is "any charge payable directly or indirectly by the consumer and imposed directly or indirectly by the creditor as an incident to or a condition of the extension of  credit." (12 CFR 226.4) Although the definition appears fairly straight forward, there are several important components worth highlighting.

• First, the definition is limited to those fees paid by the borrower. Generally, fees paid by third parties are not part of the finance charge.
• Keep in mind that the fee may be paid directly or indirectly by the borrower. So, an origination fee that is paid directly in cash by the borrower at closing would be considered a finance charge. The same is true if the borrower pays the origination fee indirectly by financing it over the term of the loan—it is still considered a finance charge.
• Another important component of the finance charge definition relates to who imposes the fee. The finance charge only includes fees directly or indirectly imposed by the creditor as a condition of credit. Fees directly imposed by the creditor are fairly easy to identify. A common example of such a fee would be the interest that is charge on the loan.

Fees imposed indirectly by the creditor are sometimes a little more difficult to identify. They usually involve third party fees being passed on to the borrower. One example of a third party fee that is a finance charge is the fee imposed for a credit report. The fee is charged to the creditor by the credit reporting agency, however, the creditor typically passes the fee onto the borrower for payment. Because the borrower ultimately pays the credit report fee and because it is imposed by the creditor as a condition of credit, the fee meets the definition of a finance charge.

Exclusions from the definition

Unfortunately the law contains some exceptions to the general definition. In other words, fees that normally would be included in the finance charge are specifically excluded if certain conditions are met. Two important areas where fees may be excluded from the finance charge involve loans secured by real estate and loans involving certain types of insurance protection.  

Loans Secured by Real Property or a Principal Dwelling

Reg Z specifically excludes certain fees associated with loans secured by real property or loans to purchase a principal dwelling (the primary residence of the consumer). In fact, Reg Z provides a long list of fees that can be excluded from the finance charge in most real estate-related transactions.

Fees for determining ownership and boundaries.  At the top of this list are fees for determining ownership and boundaries. This would include fees for the title exam, abstract, title insurance, property surveys, etc. Even though these fees meet the definition of a finance charge, they are specifically excluded because of the type of loan that is being made.

Charges for document preparation.  This involves charges for preparing the paperwork to close the loan, such as fees for preparing the deed or mortgage, settlement statements, and other related documents. This means the classic "document prep" fee is not going to be a finance charge in a real estate loan. The exclusion covers attorneys' fees to prepare the paperwork and also to attend the closing, if necessary to review the paper work or title work prepared.

Fees to assess value or condition of property. Reg Z also exempts from the finance charge fees to assess the value or condition of the property securing a loan. Appraisal fees, environmental inspections fee, flood determinations fees, etc. are included in this category.  It is important to note that this list is not exclusive. Other fees may also qualify if related to determining the true value of the real estate or integrity of the structure. So, for example, a termite inspection fee charged to all borrowers who purchase a residential dwelling may be excluded from the finance charge. The termite inspection fee is being assessed to help the lender determine the condition and value of a dwelling and would therefore qualify for an exclusion.

Miscellaneous fees. Finally, Reg Z excludes from the definition of a finance charge various miscellaneous charges such as notary fees, credit report fees, and certain escrowed amounts if charged in connection with a real estate loan. Typically such fees are a part of the finance charge, but, again, if imposed in a real estate related transaction they are treated as exempt. So, for example, a credit report fee charged in connection with a car loan would be a finance charge. However, that same credit report fee would be excluded from the finance charge in a loan to purchase a principal dwelling.

Insurance Premiums

A second group of fees which may be excluded from the finance charge are premiums for various types of insurance coverage. Included are insurance premiums that protect the borrower's ability to repay the loan, as well as insurance premiums that protect the property securing the loan. In order for such premiums or charges to be excluded from finance charge, the lender must meet certain conditions, which vary depending upon the type of insurance involved.

Credit life, accident, health and loss of income insurance. Under Reg Z, certain types of insurance premiums that protect the borrowers' ability to repay the loan may be excluded from the finance charge. Included are premiums for credit life, accident, health, and loss-of-income insurance. In order for lenders to exclude such premiums from the finance charge, the following conditions must be met.

• First, the lender cannot require the insurance as a condition of credit. The insurance coverage must be voluntary on the part of the borrower and this fact must be disclosed to the borrower.
• Second, the lender must disclose the premium for the initial term of insurance coverage. If the period of insurance coverage is for less than the length of the loan, the term of the insurance must also be disclosed.
• Finally, the lender must obtain an affirmative request for the insurance. This means the borrower must sign or initial a statement that insurance coverage is desired. Once these three conditions are met, the lender may safely exclude the insurance premium from the finance charge.

Property Insurance. A second type of insurance premium that may be excluded from the finance charge is property insurance to protect the collateral securing the loan. Such insurance may include property loss or damage insurance, liability insurance arising from use of the property, etc. Unlike the credit-life insurance, the lender may require property insurance. However, in order to exclude the premiums from the finance charge amount, the lender must, again, make certain disclosures.

• First, the lender must disclose to the borrowers that they may obtain insurance from the provider of their choice.  So you may not dictate where the insurance is purchased, as long as it meets your requirements.
• If the borrowers choose to purchase the insurance from the lender, the lender must also disclose the premium amount and the term of insurance coverage.

As with the credit life type insurance, if these disclosures are given, you may safely exclude the insurance premium from the finance charge. Reg Z provides model language for the disclosures required to exclude insurance premiums from the finance charge.  If the model language is used you will be deemed to be in compliance with Reg Z.

Excluded Fees Must Be Reasonable

Keep in mind that Reg Z allows fees to be excluded from the finance charge only to the extent that those fees are bona fide and reasonable. Attempts to exclude fees that have been marked up, lumped together or listed generically may be challenged.

In order to avoid such controversy, it is probably best to separate out all fees so that they can be scrutinized individually.  Also, remember that certain fees which are "marked up" or otherwise inflated should be broken down so that the portion of the fee which can be safely excluded from the finance charge is excluded, and that remaining amounts are added into the finance charge.

Conclusion

Knowing what is and what is not a finance charge can be complicated. Yet in this era of aggressive lending practices, and new and creative fee structures, you  must fully understand when a particular fee needs to be included in the finance charge. Making the wrong decision could result in an incorrect finance charge, which, in turn, could get you into trouble with your borrowers and your examiners.