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Comply Or Else

Understanding distinction between "inquiry" and "application" is important for Reg B compliance

April 16, 2002

By TIM MEREDITH


Do You Know Your Applications From Your Prequalifications?

Many mortgage lenders offer formal or informal information to prospective mortgage loan applicants before the consumer submits a written loan application. Those activities may include:

  • Formal prequalification or certification programs, in which you apply basic underwriting standards (such as housing and debt ratios) to the prospective applicant's situation. Sometimes lenders provide "preapproval certificates" that identify the maximum loan amount for which the consumer might qualify. These certificates are usually subject to a number of conditions, such as satisfactory property appraisal and further verification of income, employment and credit history. Some prequalification programs even provide a preliminary evaluation of credit history.
  • Homebuyers' forums and seminars, in which a variety of real estate experts (lenders, real estate brokers, lawyers, appraisers, etc.) provide information about the home buying process and what may be required at each step.
  • Informal or undocumented conversations between prospective applicants and lender representatives, in which potential applicants may be encouraged, counseled or coached as to their qualifications and what information they might need to provide in order to strengthen their applications.

These and other similar activities allow consumers to shop more effectively for a loan and/or property that they can afford. Such programs can also be a key element in your effort to reach into low- and moderate-income markets and can increase the success of first time homebuyer programs. Prequalification advice and assistance can also be an important part of a lender's community reinvestment strategy.

You should note, however, that prequalification services must be provided equitably to all customers and that none of the criteria used to prequalify or advise the potential applicant may explicitly or in effect, include illegal discriminatory factors. The Equal Credit Opportunity Act (ECOA) and Fair Housing Act (FHA) identify a number of factors that are illegal to use in evaluating a prospective applicant's qualifications:

  • Race (ECOA & FHA)
  • Color (ECOA & FHA)
  • Religion (ECOA & FHA)
  • Sex (ECOA & FHA)
  • National Origin (ECOA & FHA)
  • Marital Status (ECOA)
  • Age (provided the applicant has the legal capacity to contract) (ECOA)
  • Source of income derived from public assistance (ECOA)
  • Good faith exercise of rights under the Consumer Credit Protection Act (ECOA)
  • Handicap (FHA)
  • Familial Status (families with dependents under age 18) (FHA)

You have the discretion to decline oral or written applications, as long as the decision is based on legitimate underwriting standards and not one of the prohibited bases listed above. You can also counsel prospective customers on possible credit or underwriting problems, even if this information discourages a customer from filing a formal application. It is important to recognize, however, that prequalification programs can generate "applications" for purposes of Regulation B, the implementing regulation for ECOA, and thus trigger notification and record keeping requirements under ECOA and the Home Mortgage Disclosure Act (HMDA).


What Is An "Application?"
Understanding the distinction between an "inquiry" and an "application" is important for compliance with Regulation B because several requirements apply only to applications (not inquiries). Regulation B defines a loan application as:

    ...an oral or written request for an extension of credit that is made in accordance with the procedures established by a creditor for the type of credit requested. (Emphasis added.)

The Federal Reserve's staff interpretations of Regulation B further clarify that the phrase "procedures established":

    ...refers to the actual practices followed by a creditor for making credit decisions as well as its stated application procedures. For example, if a creditor's stated policy is to require all applications to be in writing on the creditor's application form, but the creditor also makes credit decisions based on oral requests, the creditor's established procedures are to accept both oral and written applications.

In other words, in some circumstances, an informal inquiry, whether verbal or in writing, must be treated as an application pursuant to Regulation B.

The next section of the interpretations describes one critical circumstance where a lender may turn an oral inquiry into an application, even if the lender's policy is to accept only written applications:

A creditor is encouraged to provide consumers with information about loan terms. However, if in giving information to the consumer the creditor also evaluates information about the applicant, decides to decline the request, and communicates this to the applicant, the creditor has treated the inquiry as an application and must then comply with the [adverse action] notification requirements under Section 202.9. Whether the inquiry becomes an application depends on how the creditor responds to the applicant, not on what the applicant says or asks.
(Emphasis added.)

If you tell a potential borrower that he or she will not qualify for a loan, according to Regulation B, you must treat the inquiry as an application and the response as adverse action. If you collect enough information to deny a loan, and tell the consumer that he or she is denied, will be denied or just plain should not bother applying because he or she will be denied, this interaction between you and the prospective borrower is an "application" for the purposes of Regulation B. This is true, regardless of the amount of information you collect, whether or not you have formal application procedures, whether or not you collect an application fee, whether or not the prospective applicant has identified a specific property or loan amount, or whether the communication is written or verbal.

Inquiry vs. Application
In some instances, the distinction between an inquiry and a denied application can be unclear. In recognition of lenders' confusion about Regulation B and prequalification programs, the Federal Reserve's staff interpretations specifically state that:

    Whether a creditor must provide a notice of action taken for a prequalification or preapproval request depends on the creditor's response to the request ... . For instance, a creditor may treat the request as an inquiry if the creditor provides general information such as loan terms and the maximum amount a consumer could borrow under various loan programs, explaining the process the consumer must follow to submit a mortgage application and the information the creditor will analyze in reaching a credit decision. On the other hand, a creditor has treated a request as an application, and is subject to the adverse action notice requirement of section 202.9 if, after evaluating information, the creditor decides that it will not approve the request and communicates that decision to the consumer. For example, if in reviewing a request for prequalification, a creditor tells the consumer that it would not approve an application for a mortgage because of a bankruptcy in the consumer's record, the creditor has denied an application for credit.

The staff interpretations provide some examples of situations in which only an inquiry has taken place. It is an inquiry:

    ...when a consumer calls to ask about loan terms and an employee explains the creditor's basic loan terms, such as interest rates, loan-to-value ratio and debt-to-income ratio.

Collecting vs. Evaluating Information
Even if you collect information from a customer, an inquiry may still not be an application. The staff interpretations also clarify that it is not an application:

    ...when a consumer asks about terms for a loan to purchase a home and tells the loan officer her income and intended down-payment, but the loan officer only explains the creditor's loan-to-value policy and other basic lending policies, without telling the consumer whether she qualifies for the loan.

Communication:
Disclosing Underwriting Guidelines vs. Taking Adverse Action

Communicating with a prospective applicant could still qualify as an inquiry if you determine that the consumer's debt and housing ratios exceed the amounts permitted under your underwriting standards, but point out the compensating factors that could be taken into account that might allow a loan to be approved. In contrast, if you fail to point out that it is within your discretion to consider positive compensating factors, and the consumer is left with the impression that you will not approve the loan, then the discussion would have turned an inquiry into a denied application.

In these examples, the determining factor in classifying a particular scenario with a prospective applicant as an inquiry or an application is whether you give the consumer the idea that the application will not be approved. Note that the denial does not have to be explicit in nature and can be construed as any communication that would lead a reasonable person to conclude that the application would receive negative consideration.

In contrast to declined applications, as long as prospective applicants are being encouraged to proceed, lenders have reasonable discretion in defining what constitutes an application. The Regulation B staff interpretations indicate that "a creditor has the latitude under the regulation to establish its own application process and to decide the type and amount of information it will require from credit applicants." For example, within the flexibility provided by Regulation B, some lenders might consider prequalification certificates to constitute an application, while others might require a borrower to have a contract to purchase a property and file a formal written application in order to generate an application.

When Is An Adverse Action Notice Required?
ECOA requires you to create a paper trail for all inquiries -- including prequalifications -- that meet the Regulation B definition of an "application." Specifically, for all applications, whether written or verbal, Regulation B provides that:

    ...a creditor shall notify an applicant of action taken within:

      (i) 30 days after receiving a completed application concerning the creditor's approval of, counteroffer to, or adverse action on the application;

      (ii) 30 days after taking adverse action on an incomplete application, unless notice is provided in accordance with paragraph (c) of this section;

      (iii) 30 days after taking adverse action on an existing account; or

      (iv) 90 days after notifying the applicant of a counteroffer if the applicant does not expressly accept the credit offered.

Such notices:

    ...shall be in writing and shall contain: a statement of the action taken; the name and address of the creditor; a statement of the provisions of section 701(a) of the act; the name and address of the federal agency that administers compliance with respect to the creditor; and either:

      (i) A statement of specific reasons for the action taken; or

      (ii) A disclosure of the applicant's right to a statement of specific reasons within 30 days, if the statement is requested within 60 days of the creditors notification.

Obviously, these provisions affect mortgage prequalifications. In situations where a prequalification meets the Regulation B definition of an "application," you will need to provide a written adverse action notice. This is true regardless of where the applicant is in the prequalification process or how much (or little) information has been collected by the lender.

Must An Application Be In Writing?
Regulation B requires you to maintain files documenting written applications for mortgages on dwellings occupied as a primary residence. The Commentary to Regulation B provides that:

    ...The regulation requires written applications for the types of credit covered by section 202.13(a). A creditor can satisfy this requirement by recording in writing or by means of computer the information that the applicant provides orally and that the creditor normally considers in a credit transaction.

    Credit applications covered by Section 202.13(a) include those:

    ...primarily for the purchase or refinancing of a dwelling occupied or to be occupied by the applicant as a principal residence, where the extension of credit will be secured by the dwelling . . ..

This section also requires lenders to request information regarding:

  • Race or national origin, using the categories American Indian or Alaskan Native; Asian or Pacific Islander; Black; White; Hispanic; or Other
    (Specify);
  • Sex;
  • Marital status, using the categories Married, Unmarried and Separated; and
  • Age.

Regulation B does not, however, require that the applicant complete a written application. The Regulation B staff interpretations state that:

    The requirement of written applications for certain types of dwelling-related loans is intended to assist the federal supervisory agencies in monitoring compliance with the ECOA and the Fair Housing Act?. The creditor may complete the application on behalf of an applicant and need not require the applicant to sign the application. (Emphasis added.)

Thus, if you decline oral applications (e.g., prequalifications), you must create an "application" to comply with Regulation B.

Must A Prequalification Be Reported For Regulation C (HMDA) Compliance?
Most lenders with an office or branch in a Metropolitan Statistical Area are subject to the HMDA and Regulation C. Covered lenders are required to collect and maintain a list, the Loan Application Register (LAR), containing information about home purchase, refinance and home improvement loans. Covered lenders are expected to track, among other data, the disposition of each loan application, including denials.

Applications on the LAR are reported in one of several action categories, including:

  • Originated
  • Approved but not accepted
  • Denied
  • Withdrawn, and
  • File closed for incompleteness.

These action categories reflect a final action on an application. Because prequalifications are preliminary in nature, they may not exactly fit into any of these stated action categories. This classification problem can result in incorrect reporting of prequalification data and can distort the HMDA data analysis.

In recognition of the problem, the Federal Reserve Board has determined that lenders may elect to not report prequalification requests on the LAR. The Federal Reserve staff commentary published on December 11, 1995, states that:

Board interpretations that appear in the official staff commentary to Regulation B (Equal Credit Opportunity, 12 CFR Part 202, Supplement I) are generally applicable to the definition of an application under Regulation C. However, under regulation C, the definition of an application does not include prequalification requests. (Emphasis added.)

It is essential to remember, however, that the exemption from HMDA reporting requirements does not extend to Regulation B requirements regarding adverse actions or written applications. The Regulation C staff commentary notes that:

    ...Regulation C does not require an institution to report prequalification requests on the HMDA-LAR, even though these requests may constitute applications under Regulation B.

However, you need to be careful in using this prequalification exemption, especially in situations that constitute a denial under Regulation B. In many cases, a denial under a prequalification program is based on the credit history of the applicant and may be issued prior to the selection of a specific property or loan amount. Since information on property location and loan amount are necessary to complete the LAR, or analyze the resulting HMDA reports, it would be appropriate to treat this as an exemption. In contrast, denials where the lender knows the property location and loan amount can be included on the LAR.

Lenders should be alert that this exemption is temporary. The Federal Reserve Board recently amended Regulation C (effective for applications taken in 2003). The final rule captures a specific, limited type of preapproval program. Preapproval programs covered by the final rule involve decisions based on a comprehensive credit underwriting in which a lender collects and reviews the information it typically collects and reviews in making a credit decision on a traditional application. For a preapproval program to be covered, the lender must issue a binding written commitment for approved applicants. A covered preapproval may be subject only to a limited set of conditions. These include:

  • Identification of a property;
  • Verification that the applicant's financial situation has not changed since the request was approved; and
  • Other conditions unrelated to creditworthiness that are typically included in traditional loan commitments (such as satisfactory completion of a home inspection or proof of a termite inspection).

In other words, a "preapproval" involves a written commitment to make a loan after a full credit underwriting. To be a covered preapproval program, the written commitment issued under the program must result from a full review of the creditworthiness of the applicant, including any verification of income, resources and other matters typically completed as part of the credit underwriting for a loan. The commitment can be contingent on the following:

  • The consumer must locate a property that supports the loan.
  • The lender must verify that no material change has occurred in the applicant's financial condition or creditworthiness.
  • Any other conditions (unrelated to the financial condition or creditworthiness of the applicant) that the lender ordinarily attaches to a traditional home mortgage application approval. These conditions are limited to conditions such as requiring an acceptable title insurance binder or a certificate indicating clear termite inspection, and, in the case where the applicant plans to use the proceeds from the sale of the applicant's present home to purchase a new home, a settlement statement showing adequate proceeds from the sale of the present home.

Other Considerations
Lenders offer a wide variety of programs and services to assist customers in selecting and qualifying for various mortgage loan options. You need to consider ECOA, HMDA and FHA and their implementing regulations when designing and managing prequalification programs and services. In particular, you should be aware that prequalifications are subject to ECOA and FHA prohibitions from making oral or written statements that would discourage an applicant from pursuing an application based on any of the prohibited bases.

As a precautionary measure and management tool, you may want to consider monitoring adverse action notices and application files to prevent, detect, monitor, and correct illegal discrimination. The time between the initial contact with the prospective borrower and the submission of a formal written application (the stage where prequalifications occur) is a stage where discrimination, intentional or not, is difficult to monitor, detect and prevent. Monitoring adverse action notices is one effective technique for encouraging and monitoring compliance with fair lending requirements during this period. This kind of monitoring program could be part of a your audit and control systems.

Some lenders have developed "second review" programs in which applications that are likely to be denied are reviewed to ensure that all possible avenues for approval have been explored prior to formal denial. Prequalification "rejections" should be candidates for any internal program that takes a second look at rejected applications. Every creditor should make sure that those verbal and prequalification denials are given the same consideration as more formal applications.

Finally, monitoring prequalification decisions can be a powerful training tool to remind your loan officers and underwriters of the importance of carefully considering all alternatives and compensating factors before turning away a prospective applicant. This reminder can help to guard against inadvertent or intentional discrimination. It can also help ma