Avoiding Financial Disasters with Net Tangible Benefit Disclosures

By Adelina Olsen, DocuTech Legal & Compliance Specialist

After Hurricane Katrina devastated part of Louisiana, killing hundreds of people and leaving thousands homeless, federal and state governments and many other groups and entities started working together to clean, rebuild and take necessary precautions to prevent another disaster. As part of the reconstruction process, a tourism campaign was started to encourage people from other states to visit Louisiana bringing necessary income back to local businesses.

Just like the plight in Louisiana, the national mortgage crisis was fatal for hundreds of lending companies, left thousands of people without jobs, hundreds of thousands without homes and the numbers continue to grow. As a result, a "reconstruction" of the lending process was necessary. Since then more and more states have adopted procedures to prevent the mistakes of the past from being repeated. The federal government is also working hard to eliminate mortgage fraud and abusive lending and encouraging borrowers with low interest rates and incentives through HUD and FHA programs.

Adding the names of brokers or loan originators on loan documents, complex disclosures, notices on colored paper or colored lettering and fraud notices informing potential borrowers (in a very intimidating way) of the consequences of providing wrongful information, are just a few examples of measures taken by states and federal government to avoid things getting worse.

Among all of these measures, an increasing number of state legislatures require that lenders prove a net tangible benefit on refinances done within a certain period of the date of the original loan. Colorado was the first state to require all licensees to prove a net benefit even on first liens, more states may join them in the future. It should be simple to prove the benefit of a refinance or else why would the borrower seek one? The tricky part is proving a "net" tangible benefit - where the benefit received outweighs the cost of the transaction.

There are four main reasons for a borrower to seek a refinance:

1. Reduce costs
2. Raise cash
3. Reduce monthly payments
4. Reduce interest rate risk

These reasons are legitimate and offer real benefits to the borrower.

In a cost-reduction refinance, the new interest rate or mortgage insurance premium is lower than in the existing loan. A net benefit will exist if the future savings with the new rate or insurance premium outweigh the upfront costs incurred by the borrower.

Cash out refinances are the most susceptible for abuse, where the motive is to raise cash. Usually the new interest rate will increase and the borrower will still have to bear the upfront costs of the refinance. Other than the "extra cash" there might be no other benefit for this transaction, but in most cases the borrower is willing to pay the costs in order to afford emergency expenses.

Some argue that the benefit on a payment reduction refinance may never be realized, where the borrower reduces his current payments in exchange for higher payments in the future. Payment reduction usually involves converting a fixed rate loan into an adjustable rate loan carrying a lower rate, often with an interest only option for a limited period. Once again, that might be a substantial benefit to the borrower and he may gladly pay the difference in exchange for momentary relief in payments.

When borrowers are willing to refinance into a higher rate now to reduce interest rate risk in the future, the net benefit is securing a future rate when rates are expected to rise.

Some of these "benefits" are easy to prove when the lender provides a written disclosure with a worksheet comparing the old loan to the new loan. However, not all states require a written net tangible benefit disclosure. The chart below shows the states that require a net tangible benefit with a comparison between new and old loans (worksheet) and if the states have created a specific form to be used:

Even with legitimate reasons for a refinance, a borrower may not know or understand the implications of his choices.  This makes it easier to understand how a refinance can go wrong.  This also highlights that a net tangible benefit disclosure is the best way to safeguard the lender from reckless lending and give the borrower another chance to learn the implications of his choices.

If there is a lesson for "survivors" of this catastrophic event, it is that you can never be over protected. Whatever steps lenders can take to avoid fraud and keep borrowers as well informed as possible, will be useful in preventing future problems and may also bring back the confidence that the lending market is "flood proof".