Except for those homebuyers who are able to pay cash to buy a house, residential mortgage lending makes homeownership possible for those who must finance the purchase of their home. Among the myriad of home mortgage products available to consumers, a “higher-priced mortgage loan” (HPML) follows certain guidelines under Section 35. These rules establish parameters that include qualifying for an HPML, setting up an escrow account and obtaining an appraisal for eligible HPML properties.
What Is Section 35?
Section 35 actually refers to the numbered section of Part 1026 of bank Regulation Z, which is also called Truth in Lending (TIL) because of the same-named Truth-in-Lending Act (TILA). Enacted by Congress in 1968 and implemented by the Federal Reserve Board, the TILA offers protection for consumers and lenders by providing transactional transparency through full disclosure of certain lending details.
Features of the Truth-in-Lending Act
The TILA covers most types of consumer credit such as open-end credit, which includes credit cards, and closed-end credit, which includes mortgages. The TILA requires lenders to reveal details of their products and services so that consumers can be fully informed to make their credit decisions. Subpart E (Special Rules for Certain Home Mortgage Transactions) of the TILA contains Sections 31 through 45, which outline the rules and requirements for some types of mortgages, including Section 35 (requirements for higher-priced mortgage loans).
Section 35 Residential Mortgage Loans
Real-estate lenders offer mortgages in three basic categories – residential, commercial and industrial. Real estate includes the land as well as the buildings and other structures on it. Lenders make residential mortgage loans for real estate, such as houses, town homes and condominiums; commercial mortgage loans for real estate, such as retail buildings, office buildings and warehouses; and industrial mortgage loans for real estate, such as factories and farms.
Section 35 rules apply only to residential real estate for a consumer’s principal dwelling. This dwelling must be a single-unit house or a multi-unit home up to four units, regardless of whether the dwelling is attached to real property. For example, a Section 35-eligible property can also be an individual condominium unit, a cooperative unit, or a mobile home or trailer, as long as these homes are used as the consumer’s principal dwelling.
Higher-Priced Mortgage Loans (HPMLs)
An HPML is specifically defined as “a closed-end consumer credit transaction that’s secured by the consumer’s principal dwelling.” The “higher” in a Section 35 higher-priced mortgage loan means that the loan’s average percentage rate (APR) is higher than the average prime offer rate (APOR) for a comparable transaction. Section 35 defines APOR as the “annual percentage rate that is derived from average interest rates, points, and other loan pricing terms currently offered to consumers by a representative sample of creditors for mortgage transactions that have low-risk pricing characteristics.”
The three percentage point benchmarks that characterize HPMLs are:
- 1.5 percent. The rate at which an HPML exceeds the prime rate for a first-lien mortgage, which has a principal balance that does not exceed Freddie Mac’s maximum principal obligation for purchase.
- 2.5 percent. The rate at which an HPML exceeds the prime rate for a first-lien mortgage, which has a principal balance that does exceed Freddie Mac’s maximum principal obligation for purchase.
- 3.5 percent. The rate at which an HPML exceeds the prime rate for a subordinate-lien mortgage.
Higher-Priced vs. High-Cost Mortgages
Although the terms may sound as though they describe the same product, a higher-priced mortgage is not the same as a high-cost mortgage. The requirements for both of them, however, are listed under the same Subpart E of the Truth-in-Lending mortgage guidelines. HPMLs are addressed in Section 35, and high-cost mortgages are addressed in Section 32.
Section 32 loans have been so-named since 1994, when the Home Ownership and Equity Protection Act (HOEPA) was passed to curb abusive lending practices that included high fees and high interest rates. The resulting high-cost loans are also called HOEPA loans or Section 32 loans. It’s a misnomer to refer to a mortgage as an HOEPA Section 35 loan, because these loans are correctly called HOEPA Section 32 loans.
HOEPA Section 32 loans must also meet the same APR and APOR criteria as Section 35 loans, but Section 32 loans also include these three additional criteria, which do not apply to Section 35 loans:
- The APR is higher than the APOR by more than 6.5 percent.
- Total lender/broker points and fees are greater than 5 percent of the total loan amount. This percentage includes certain fees such as origination fees, broker fees, processing fees and servicing setup fees.
- A prepayment penalty exceeds 2 percent of the prepaid amount or occurs more than 36 months after closing.
Section 35 Freddie Mac Compliance
One of the big players in the secondary mortgage lending market is the Federal Home Loan Mortgage Corporation (FHLMC), commonly called Freddie Mac. Secondary mortgage lenders do not finance mortgage loans; they purchase mortgages from lenders in the primary mortgage market such as banks, savings and loans and credit unions. For a primary lender to sell a mortgage loan to Freddie Mac, it must follow Freddie Mac guidelines for the mortgage. Any mortgage that doesn’t comply with Freddie Mac guidelines is rejected by Freddie Mac’s risk-management seller/servicer software.
This is why Section 35 mortgages require Freddie Mac compliance. An HPML is more expensive than other types of mortgages because of its higher interest rate, which means that the borrower’s eligibility must conform to certain underwriting guidelines to mitigate the loan’s default risk.
Section 35 Freddie Mac-Eligible Loans
Freddie Mac purchases only certain types of HPML products, based on these loan application-received dates:
- For mortgage loan applications that were received on or after October 1, 2009 and prior to October 15, 2014, Freddie Mac will purchase eligible HPMLs that are fixed-rate mortgages or adjustable rate mortgages (ARMs) with 7/1 or 10/1 terms. These HPMLs cannot be prepayment penalty mortgages or ARMs with an initial fixed-rate period of less than seven years.
- For mortgage loan applications received on or after October 15, 2014, Freddie Mac will purchase eligible HPMLs that are fixed-rate mortgages or ARMs with an initial fixed-rate period of five, seven or 10 years.
Section 35 Escrow Account Rules
A lender cannot extend an HPML without setting up an escrow account to collect premium payments for property taxes and mortgage-related insurance. Insurance includes coverage for property loss or damage, liability or protection for the lender against the borrower’s default or other credit loss. Types of insurance not required under Section 35 include earthquake insurance or credit life insurance.
Section 35 Escrow Account Exemptions
Escrow accounts do not have to be established in these cases:
- Transactions that are secured by cooperative shares.
- Transactions that finance a dwelling’s initial construction.
- Temporary or bridge loans that have loan terms of 12 months or less, for example, a purchase loan for a new dwelling when the borrower plans to sell his current dwelling within 12 months.
- Reverse mortgages subject to Section 1026.33 of the TILA, “Requirements for reverse mortgages.”
- Certain properties that are located in rural or underserved areas, as defined by the Section 35 rules.
Section 35 Rural Properties
Section 35 rules include certain rural and underserved properties, for which lenders do not have to establish escrow accounts. The Section 35 rules only apply if the property is designated rural or underserved as of the date the borrower signs the mortgage note, also known as the time of consummation. All descriptive terms of these two types of properties must conform to definitions in the Urban Influence Codes (UICs) of the U.S. Office of Management and Budget, established by the United States Department of Agriculture’s Economic Research Service (USDA-ERS).
Eligible rural properties are characterized by these two parameters:
- Counties that are located neither in a metropolitan statistical area or in a micropolitan statistical area that’s adjacent to a metropolitan statistical area. The U.S. Census Bureau defines a metropolitan statistical area as one that includes at least one urbanized area of 50,000 or more inhabitants. A micropolitan statistical area must include at least one urban cluster of at least 10,000 but fewer than 50,000 inhabitants.
- Census blocks that are not located in an urban area, determined by the U.S. Census Bureau’s most recent 10-year census count.
Section 35 Underserved Properties
An eligible “underserved” property, for which lenders do not have to establish an escrow account, is one for which no more than two lenders made Section 35 loans five or more times. This data must be verified according to the Home Mortgage Disclosure Act (HMDA) for transactions that were made during the preceding calendar year.
Section 35 Appraisal Rules
Before a lender can approve a Section 35 mortgage, the property must be appraised. The appraisal must be a written report performed by a certified or licensed appraiser, and it must include a review of the property’s interior. “Written” includes any copy of a written appraisal such as a digital format, which is transmitted electronically, as long as the transmission has the borrower’s consent and complies with the provisions of the Electronic Signatures in Global and National Commerce Act.
Appraisers must be certified or licensed in the state in which the Section 35 property is located, and their certification or licensure must be subject to the Uniform Standards of Professional Appraisal Practices. An appraiser must also meet the Title XI requirements of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 and all applicable amendments at the time she signs the appraisal certification for a Section 35 property.
When Two Appraisals Are Required
Some HPMLs require an additional appraisal for a total of two written appraisal reports, generally in these two cases:
- The seller acquired the property 90 days (or fewer) before the borrower’s agreement to purchase the property, and the borrower’s agreement price is greater than the seller’s acquisition price by more than 10 percent.
- The seller acquired the property 91 to 180 days before the borrower’s agreement to purchase the property, and the borrower’s agreement price is greater than the seller’s acquisition price by more than 20 percent.
If two appraisals are required, the reports cannot be performed by the same appraiser. At least one of the two appraisals must include these analyses:
- The price difference between the seller’s acquisition price and the buyer’s price, as stated in the purchase agreement.
- The changes in market conditions between the seller’s acquisition date and the buyer’s purchase agreement.
- A listing of all improvements made to the property between the seller’s acquisition date and the buyer’s purchase agreement.
- Govinfo.gov: U.S. Government Publishing Office - Part 1026, Truth in Lending (Regulation Z)
- Investopedia: Truth in Lending Act (TILA)
- Scotsman Guide: High-Cost Vs. Higher-Priced Mortgages
- Consumer Financial Protection Bureau: 2013 Home Ownership and Equity Protection Act (HOEPA) Rule Guide
- Freddie Mac: Seller-Servicer Guide, Published 11/13/19
- United States Census Bureau: About Metropolitan and Micropolitan