Mortgage Prepayment Penalty Restrictions

Issued and entered this 2nd day of September 2003 by Linda A. Watters Commissioner

The Office of Financial and Insurance Services (OFIS) has been presented with several inquiries concerning the possible preemption of Michigan's restrictions on prepayment fees and penalties. These inquiries have centered on two questions: 1) whether MCL 438.31c(2)(c) is preempted generally by Section 501(a)(1) of the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA); 2) whether Michigan's restrictions of mortgage prepayment fees and penalties have been specifically preempted when the loan is an "alternative mortgage transaction."

OFIS Position

• Section 501(a)(1) of DIDMCA, 12 USC 1735f-7a, does not preempt MCL 438.31c(2)(c). As a result, lenders that make loans secured by first mortgages on residential property, except for certain alternative mortgage transactions, are prohibited from charging a Michigan consumer a prepayment fee or penalty in excess of or beyond the time restriction set forth in MCL 438.31c(2)(c).
• The provisions of MCL 438.31c(2)(c) that limit the charging of prepayment fees and penalties, in certain instances, are preempted by the Alternative Mortgage Transaction Parity Act of 1982 (AMTPA), 12 USC 3802.

This bulletin outlines the limits of Section 501 of DIDMCA and the preemptive effect of the AMTPA on provisions of Michigan law that prohibit or limit the collection of loan prepayment fees or penalties.

I. Section 501 of DIDMCA

Subsection (2)(c) of MCL 438.31c contains Michigan's statutory limitation on the ability of lenders to restrict mortgage loan prepayments on first lien residential mortgages and provides, in pertinent part, as follows:

MCL 438.31c(2)(c)

"In connection with the transaction, except a loan, insured or guaranteed by the federal government or any agency of the federal government, if the security is a single family dwelling unit, the lender shall not do any of the following:

(c) Charge a prepayment fee or penalty in excess of 1% of the amount of any prepayment made within 3 years of the date of the loan, or any prepayment fee or penalty at all thereafter, or prohibit prepayment at any time."

Section 501(a)(1) of DIDMCA expressly preempts state usury laws applicable to first lien residential mortgages: "The provisions of the constitution or the laws of any State expressly limiting the rate of interest, discount points, finance charges, or other charges which may be charged, taken, received or reserved shall not apply to any loan, mortgage, credit sale, or advance" that is secured by a first lien on residential real property. Federal regulation 12 CFR 590.3(c), states however, that DIDMCA does not preempt a "limitation in state laws on prepayment charges . . . or other provisions designed to protect borrowers."

The legislative history of DIDMCA's preemption provision clearly indicates the intent of Congress to preempt state limitations on charges included in the "annual percentage rate." The annual percentage rate reflects the amount of finance charge for the credit. The finance charge is the sum of charges, payable directly or indirectly by the person to whom the credit is extended, and imposed directly or indirectly by the creditor as an incident to the extension of credit. In 1991, the Attorney General cited the legislative history to clarify the scope of the federal preemption, stating in part, "In exempting mortgage loans from state usury limitations, the Committee intends to exempt only those limitations that are included in the annual percentage rate. The Committee does not intend to exempt limitations on prepayment charges, attorney fees, late charges or similar limitations designed to protect borrowers." (OAG No. 6679, April 29, 1991)

Generally, prepayment charges are not deemed to be interest on the loan but ancillary fees or penalties. That is, they do not reflect the actual cost of credit but incidental expenses that a lender may incur in handling a loan. Restrictions on the amount of those fees or penalties protect borrowers from being required to pay excessive penalties or incidental expenses not related to the cost of credit. Clearly, such limitations on the charging of prepayment fees or penalties are not a part of the finance charge for the loan.

A case decided on October 29, 2002 further supports this position. In Nelson v Associates Financial Services, 353 Mich App 580 (2002), the Michigan Court of Appeals held that the prepayment penalty limitations of MCL 438.31c(2)(c) are not preempted by section 501 of the Depository Institutions Deregulation and Monetary Control Act, 12 USC 1735f-7a.

It is OFIS' position that MCL 438.31c(2)(c) is not preempted by Section 501(a)(1) of DIDMCA. Accordingly, lenders that make loans secured by first lien mortgages on residential property, except for certain alternative mortgage transactions, are prohibited from charging Michigan consumers prepayment fees or penalties other than as allowed by MCL 438.31c(2)(c).

II. AMTPA of 1982

Through the AMTPA, Congress intended to create an environment in which all "housing creditors," as that term is defined in 12 USC 3802(2), including state-licensed or state-chartered institutions, may make, purchase, and enforce "alternative mortgage transactions" in conformity with applicable federal regulations. The term "alternative mortgage transaction" is defined at 12 USC 3802(1) as:

" . . . a loan or credit sale secured by an interest in residential real property, a dwelling, all stock allocated to a dwelling unit in a residential cooperative housing corporation, or a residential manufactured home . . . [:] (A) in which the interest rate or finance charge may be adjusted or renegotiated; (B) involving a fixed-rate, but which implicitly permits rate adjustments by having the debt mature at the end of an interval shorter than the term of the amortization schedule; or (C) involving any similar type of rate, method of determining return, term, repayment, or other variation not common to traditional fixed-rate, fixed-term transactions, including without limitation, transactions that involve the sharing of equity or appreciation; described and defined by applicable regulation . . . "

Thus, AMTPA applies to all manner of mortgage instruments made by housing creditors that do not conform to the traditional fully amortized, fixed-rate, fixed-term, mortgage loan.

The preemption clause of the AMTPA provides that "[an] alternative mortgage transaction may be made by a housing creditor in accordance with this section, notwithstanding any State constitution, law, or regulation." To qualify as a non-depository "housing creditor," a person must comply with any applicable state licensing law. In making loans under the AMTPA, housing creditors must also comply with applicable federal regulations. The applicability of particular federal regulations depends on the type of creditor making the loan: national and state-chartered banks must comply with applicable regulations of the Office of the Comptroller of the Currency (OCC - applicable regulations are 12 CFR 34.20 through 34.25); state-chartered credit unions must comply with those of the National Credit Union Administration (NCUA); and all other housing creditors lending under the AMTPA must comply with the regulations of the Office of Thrift Supervision (OTS - applicable regulations are 12 CFR 560.33 through 560.35, 12 CFR 560.210, and 12 CFR 560.220) that govern alternative mortgage transactions.

The OCC has explicitly preempted state laws that block commercial banks from imposing prepayment fees or penalties in connection with alternative mortgage transactions (12 CFR 34.22). This regulation applies only to alternative mortgage transactions defined by the OCC as "adjustable rate mortgages," which are extensions "…of credit made to finance or refinance the purchase of, and secured by a lien on, a one-to-four family dwelling…where the lender…may adjust the rate of interest from time to time." Thus, the preemptive effect of this OCC regulation, as applicable to state-chartered banks, extends only to this specific type of alternative mortgage transaction (adjustable rate mortgages as defined by 12 CFR 34.20), not all types of alternative mortgage transactions.

More recently, the OTS issued regulations which remove prepayment and late fee rules from the list of OTS regulations that apply to certain housing creditors, i.e., state-chartered thrifts and state-licensed mortgage lenders) under the AMTPA. This action reverses the OTS' action in 1996 preempting state law restrictions on prepayment penalties and late charges for state-chartered depositories and state-licensed mortgage lenders. The final rule took effect on July 1, 2003.

This means that state-chartered savings banks and savings associations, state-licensed housing creditors, certain HUD lenders, and others that make mortgage loans would again be subject to state law rather than OTS prepayment and late fee rules.

The AMTPA directs the OTS, OCC, and the National Credit Union Administration (NCUA) to identify and publish regulations that are "inappropriate for and inapplicable to" state housing creditors (Section 807(b) of Pub. L. 97-320 (1982) as quoted by the OTS in 12 CFR 560.220). The three agencies have approached the designation of rules differently.

The NCUA has identified all of its lending regulations as applicable to alternative mortgages transactions made by state-chartered credit unions. Significantly, the mortgage regulations in the Federal Credit Union Act specifically prohibit prepayment penalties on any type of loan (12 USC 1757(5)(A)(viii)). This prohibition, however, applies to federal credit unions rather than federally insured credit unions. Consequently, federally insured state-chartered credit unions will be bound by this federal prohibition only if they are making a mortgage loan in reliance of the AMTPA, i.e., making a so-called "parity act" mortgage or "alternative mortgage transaction."

Any questions regarding this bulletin should be addressed to:

Office of Financial and Insurance Services
Policy Division
611 West Ottawa Street
P.O. Box 30220
Lansing, MI 48909-7720

Toll Free (877) 999-6442