South Carolina H 3627 proposes penalty of 3x payment if mortgagors fail to apply at least 30% of a mortgagee's loan payment toward the principal balance of the loan. In so doing, it both mislabels borrowers as mortgagee and lenders as mortgagors (it's the opposite) and misunderstands the mortgage math, which dictates that two factors, 1) the interest rate and 2) the term of the loan, work together to determine the amount of principal in each payment when amortizing a loan. The amount of principal starts low and increases throughout the term of the loan. The longer the term of the loan, the lower the initial percentage of principal in the payment. Imposing a minimum principal ratio in payments has the effect of setting interest rate caps on transactions of a given term. The penalties in H 3627 would shut down lending when rates exceed the effective caps and have calamitous effect on property values. Thus, H 3627 is a stark reminder to be vigilant in watching state legislation to prevent significant harm to consumers and the industry that serves them.

Effect on 30-year mortgages

The effect on a 30-year mortgage is that an interest rate of 4.02% per annum will result in at least the first payment with less than 30% principal. Take for example, a 30-year fixed rate $100,000 loan at 4.02% interest, the payment, rounded to the nearest penny, is $478.57. Interest on $100,000 at 4.02% is $4,020.00 per year or $11.16667 per day on a 360-day year. Making one month's interest (30 days) $335.00. Take the payment of $478.57 and subtract the interest to get $143.57 in principal, which is 29.999791% of $478.57. That is less than 30% so the penalty would be three times the payment amount or $1,435.71. As the rate increases, the number of payments with less than 30% principal increases. A rate of 4.25% has less than 30% principal for the first 27 payments. 4.5% has 39 payments with principal less than 30%. I bought my first house with a mortgage at 12.5%, that would have had the first 244 payments over 30%.

Servicing practices compound the risk

But wait, that payment was based on 360 days per year and there are 365 or 366 days in an actual year. If a servicer were not using a 360-day year and instead calculated its payment based on an 365 or 366 day year then the principal percentage would vary based on the month the payment was being made. A payment in February would have a higher principal amount than a payment made in January, March, or any of the other 31-day months. But there is more, the percent of principal also depends on whether the interest is charged through the date the payment is due, known as scheduled payment application (used in the preceding examples) or charged through when the payment is received, known as actual payment application. In actual payment application, the percentage of principal is dependent upon when the borrower makes the payment. Late payments one month have lower principal percentage because there are more days of interest applied in that payment. But a timely payment the next month would have a higher principal percentage because there were lesser days in that payment. H 3627 would reward borrowers with three times their payment amount for making payments late under the actual payment application approach.

Interest and principal ratios result from mathematical formulas that vary when interest rates rise and fall. Fixing the ratio by law would have the effect of setting an interest rate cap. A loan with a variable rate could have compliant payments initially and be out of compliance when the interest rate increased.

But wait, there's more... what constitutes a payment?

But that isn't all that is wrong with this bill. As drafted the borrower (mortgagor) has to pay the lender (mortgagee) three times the payment if they don't pay enough principal. Assuming that gets revised, the bill doesn't say whether the basis for the 30% comparison is the amount of the principal and interest required by the promissory note, or if it includes taxes, insurance, mortgage insurance, late fees, modification fees, foreclosure costs, or any other charges the consumer may be paying along with their payment. The number of payments with principal less than 30% described above are based only on the principal and interest portion of the payment. If the language of H 3627 were taken literally, any "payment on a loan secured by a mortgage" would have to have a 30% principal reduction. So, a borrower making a federally required contribution to make up a shortage in a tax escrow account after annual escrow analysis could argue that payment was subject to treble the amount in penalty if the lender didn't apply 30% of the money to principal. Of course, this would be an absurd outcome and a court should find such language constitutionally overbroad and require it to be narrowly construed. But would it be so narrow as to exclude the taxes and insurance escrows included in a regular monthly payment? And that doesn't address handling partial payments.

Effects of H 3627 on mortgagors - residential and commercial

If H 3627 passed in its current form (assuming a reversal of the Mortgagor/Mortgagee mixup), we can anticipate lenders ceasing to make traditional 30-year fixed rate loans in South Carolina when the rate exceeds 4.02 percent and we won't see any 30-year ARM loans either. Traditional 20-year fixed rate loans will dry up at 6.035 percent. That is a lot of South Carolina citizens that will not get a loan. But more importantly, it is a lot of homeowners whose property values will plummet when interest rates rise. The higher payments on shorter term loans will make qualifying more difficult and push buyers out of the market dropping demand and devastating the market values of real property. All real property, because this bill applies to all mortgages, not just residential loans.

Get involved and protect both industry and consumers from unintended consequences

The bill highlights a problem with legislators drafting bills with little understanding of the complexity of the topics being addressed. Mortgage laws require an understanding of the time value of money and the unanticipated effects of imposing linear math in statutory limitations. Historically, lobbyists from the affected industry reveal these types of problems and get them cleaned up before becoming law. Many bills die in committee, they may even be drafted knowing full well they will not get any traction, but they must be monitored and managed, nonetheless.

Bill's like H 3627 require the industry to be vigilant. Paid lobbyists may not know the math behind the mortgage, but mortgage professionals do. Get involved in local trade associations, join the legislative committees. Review the bills introduced in your state's legislature that could affect your livelihoods every day and speak up when you see something like this. Better yet, meet with legislators regularly, call them and remind them that if they have questions you can help them understand the industry perspective. Become a resource and fewer bills like South Carolina's H 3627 will be introduced.