The Association of Credit Union Internal Auditors, Inc., recently awarded Justin Hosie and our own Cliff Cook the Pat Richey 2023 Article of the Year for their informative and entertaining article on Regulation Z’s top 10 material violations.

TILA and Regulation Z:  Top 10 Material Violations

By: Justin Hosie^[1] and Cliff Cook^[2]

June 5, 2022

If you saw the title of this article, and decided to actually read this, then you’re either really interested in Top 10 lists (let’s hope so), really interested in the Truth in Lending Act (I’m sorry), or you’re trapped with this article on a broken phone and you literally have nothing else to look at. With the possible exception of federal and state examiners, almost no one other than your authors, and about seven other people across the country, really like thinking about the Truth in Lending Act (TILA).

But you’re nevertheless pressing on and reading this article. Odds are, that like at least one of your authors, you like Top 10 Lists. David Letterman inspired my love of these lists. As a kid, I would stay up late, way too late, and watch David Letterman read his notecard, throw pencils over his shoulder breaking fake glass windows, and deliver dry sarcasm until I fell asleep. My secret goal (besides not getting in trouble for being up so late) was to stay awake through the list. Through the years, Dave had holiday classics like the “Top 10 Least Popular Christmas Carols,” celebrity lists like the “Top 10 Things Mick Jagger Learned after 50 Years of Rock and Roll” and the “Top 10 Ways the Country Would be Different if Brittney Spears Were President.” And of course, there were political themes like the “Top 10 Favorite George W. Bush Moments,” and the “Top Ten President Obama Excuses.” I searched for the Top 10 of Dave’s Top 10 lists, and there were tons of them, though the sources didn’t coalesce around the same list. It seems that love for his humor, and these lists was clear. People love Top 10 Lists.

So, in an effort to make a rather unpopular and boring subject, the Truth in Lending Act, a bit more interesting, we’re giving you our “Top 10 List of TILA Material Violations.” This is the kind of list that would get a writer fired from a comedy show; But it is probably important, if you’re responsible for an institution’s compliance with federal consumer protection laws like TILA, or are a part of an auditing team charged with performing TILA audits. We believe it is important to know that TILA violations, which are subject to statutory damages, may require your institution to pay restitution, extend the consumer’s rescission rights, expose the institution to civil liability, and a possible wrestling-match with plaintiffs and regulatory agencies. The section of TILA addressing civil liability, 15 U.S.C § 1640 is a foreboding page turner threatening individual lawsuits and class action lawsuits.

We’re guessing you don’t want your organization to face those issues. So, without delay, “ladies and gentlemen” (ala, Letterman), here’s our list of the Top 10 issues we see during audits or consulting engagements:

1. Failure to treat loan fees, credit report fees, document prep fees, and other fees as prepaid finance charges
2. Failure to calculate the amount financed properly
3. Failing to calculate the APR based on the underlying legal obligation
4. Ambiguity regarding due dates
5. Using the simple interest rate as the disclosed APR or otherwise failing to follow Appendix J to Regulation Z
6. Failure to disclose the APR within the accuracy tolerances
7. Not disclosing a composite APR on discounted ARM Loans
8. Confusing the requirements for multiple-advance closed-end loans and open-end lines of credit
9. Failing to accurately disclose the balance subject to a finance charge on periodic statements
10. Using the wrong formulas on periodic statements

I’ll be the first to admit there’s nothing funny about the list for clients with these problems (or anyone reading this; especially if you are afflicted with a common malady, “RegZitis”). The list doesn’t get funny at the end, like Dave’s lists sometimes did. And it doesn’t end with drums and music from Paul Shaffer and the World’s Most Dangerous Band. It’s just a list of hyper technical problems you may encounter that can end up costing millions of dollars in fines, penalties, and the costs of expert witnesses and lawyers. And because we’d hate to see your institution pay fines and penalties, and experience a number of related problems, we’ll try to explain some of the key requirements, and provide ways to avoid the trouble we see organizations get into, when they’re not careful.

1. Failure to treat loan fees, credit report fees, document prep fees, and other fees as prepaid finance charges

If a finance charge is paid separately in cash or by check before or at consummation of a transaction, or withheld from the proceeds of the credit at any time, then it’s a “prepaid finance charge.” In most loans, even if you call an amount a “loan fee,” a “credit report fee,” a “document preparation fee,” an “origination fee,” or some other creative name, if it meets that definition, it’s a prepaid finance charge. Renaming your fee doesn’t change the treatment under TILA.  If it looks like a duck, swims like a duck, and quacks like a duck…well, you know the rest.

The most common examples of prepaid finance charges included buyer’s points, service fees, loan fees, finder’s fees, loan-guarantee insurance premiums, and credit investigation fees. When finance charges are paid separately or withheld from the proceeds, they are prepaid finance charges.

There are numerous reasons that getting this right is critical. One is that prepaid finance charges must be taken into account in computing the disclosed “amount financed.” Like a bad math student who stays up too late watching comedy, if you start with the wrong figures, you’re going to end up doing all of the math wrong. In this case, an incorrect amount financed may result in an understatement of both the disclosed finance charge and APR. We’ll address more on these two dreaded errors below.

2. Failure to calculate the amount financed properly

Speaking of the “amount financed,” using the incorrect amount financed violates TILA and can also sabotage the rest of your TILA disclosures. The “amount financed” is effectively the amount of credit provided to the consumer or on the consumer’s behalf. Calculating the amount financed is a three-step process. First, you must start with the principal loan amount (or cash price after subtracting any down payment in a credit sale transaction). Second, you must add amounts financed that are not part of the finance charge. Third, you must subtract the prepaid finance charges. If you skip one of those steps, you’ll violate TILA.

Beginning with the principal is critical. It involves looking to the actual credit obligation, which is sometimes called the Note or Loan Agreement, and determining the sum of money lent. This amount can include amounts for taxes, tag and title fees, and the costs of accessories or service policies that the creditor includes in the cash price.

Adding any other amounts that are financed by the creditor, but are not part of the finance charge, is also mandatory. Typical examples are real estate settlement charges and premiums for voluntary credit life and disability insurance excluded from the finance charge.

Lastly, you have to subtract the prepaid finance charges. If you already botched that, see #1 above, then you’re going to get this disclosure wrong too. These aren’t terribly hard to understand when you’re looking at finance charges paid separately at closing. Those intuitive prepaid finance charges are less likely to be included in the amount financed inadvertently.

But, in some instances, such as when loan fees are financed by the creditor, creditors will include those finance charges in the principal loan amount – effectively loaning those amounts to consumers and allowing them to repay those charges over time. When the finance charges are included in the principal loan amount, they should be deducted as prepaid finance charges when calculating the amount financed. Likewise, the same rules apply when the creditor collects the charge by withholding it from the amount advanced to the consumer. If the creditor includes the loan fee in the principal loan amount, it should be deducted when determining the amount financed. In short, the amount financed never includes finance charges. Although the principal may include finance charges, the amount financed can never include finance charges.

There are certainly other wrinkles to consider when calculating the amount financed, and this figure gets immensely more complicated on multiple-advance loans like construction loans. It is important to understand that sometimes the TILA “amount financed” is not the amount financed. But, that will only make sense if you are afflicted with the aforementioned malady.

3. Failing to calculate the APR based on the underlying legal obligation

The word “obligation” appears almost 800 times in Regulation Z (the federal regulation implementing TILA). If there’s any question, that means that if you’re going to get the TILA disclosures correct, it’s important to know and understand the obligation between the creditor and consumer. In calculating the disclosures, including the APR, one bedrock requirement is that the disclosures must “reflect the terms of the legal obligation between the parties.” If you disagree with your favorite regulator or plaintiff about the consumer’s repayment obligations, the varying interpretations could be the source of real problems for your disclosures. So, make sure your legal obligation is clear and unambiguous on the face of your consumer disclosures. One of the most common ambiguities regarding the legal obligation, concerns the due dates.

4. Ambiguity regarding due dates

As consumers and creditors seek novel repayment structures, more and more ambiguity is possible regarding the due dates. To comply with TILA’s requirements for closed-end credit, the payment schedule must disclose the “number, amounts, and timing of payments scheduled to repay the obligation.” There is some limited flexibility, and some guidance regarding certain scenarios like demand loans, multiple-advance loans, and others. But generally speaking, failing to disclose the number, amount, and timing of payments in a clear way, is going to result in calculation discrepancies. So, if you, or a regulator or plaintiff are scouring your consumer documents, and the legal obligation isn’t crystal clear in the payment schedule, then your disclosures are going to be a source of potential problems.

5. Using the simple interest rate as the disclosed APR or otherwise failing to follow Appendix J to Regulation Z

Calculating the APR on a credit transaction shouldn’t be guesswork. The rules and formulas are spelled out in Appendix J to Regulation Z, and efforts at skipping the formulas and using the contract’s “simple interest rate” do not work. First and foremost, whenever non-interest finance charges are involved, the APR will reflect inclusion of those charges, not just interest based on a rate; and as a result, the APR would be higher than the interest rate. But, even in instances when there are no fees, the APR and the simple interest contract rate will rarely be the same, because of the differing approaches for counting the number of days, weeks and months between payments, calculation rounding methods, and other considerations required by Appendix J.

6. Failure to disclose the APR within the accuracy tolerances

While you may think of TILA as a soulless beast designed to punish unwary creditors, I’ve heard regulators say that they think of the APR as the heart and soul of TILA. That’s because it’s considered to be the one mathematical figure intended to be used by consumers in comparison shopping different credit products. Under this mindset, if the APR is wrong, the purposes of TILA aren’t served, and regulators get very unhappy. With that said, there’s a small sliver of tolerance for imperfections. For a regular transaction where the creditor makes a single advance, has regular payment periods, and regular payment amounts, there’s an error threshold of 0.125%. For irregular transactions, which are transactions with multiple advances, irregular payment periods, or irregular payment amounts the tolerance is 0.250%. If creditors disclose the APR outside of these tolerances, they face statutory damages, restitution requirements, and the consumer rescission periods may continue to run.

7. Not disclosing a composite APR on discounted ARM Loans

The relationship between APRs and adjustable-rate loans is “complicated.”  With limited exceptions, the disclosures for variable-rate transactions must be given for the full term of the transaction and must be based on the terms in effect at the time the loan is originated (aka “consummation”). With exceptions, creditors should base the disclosures only on the initial rate and should not assume that this rate will increase. The exceptions mentioned have their own exceptions. In some transactions involving buydowns, discounted transactions, and premium transactions, the disclosed annual percentage rate should be a composite rate based on the rate in effect during the initial period, and the rate that is the basis of the variable-rate feature for the remainder of the term. So, for adjustable-rate mortgages, particularly those involving a seller buydown that reflected in the credit contract, a consumer buydown, or a discounted or premium rate, you would be wise to seek legal advice regarding programming and verifying composite APR calculations.

8. Confusing the requirements for multiple-advance closed-end loans and open-end lines of credit

Another common violation we see involves misunderstanding different credit products that involve multiple advances. One example involves a bank that used a closed-end note with multiple advances, rather than using a home-equity line of credit or other line of credit for home-improvement. While lines of credit and multiple-advance closed-end credit transactions both involve multiple advances, the APR calculations differ drastically. Open-end line of credit APRs are generally easier to calculate and disclose, and the transactions are easier for the consumer to understand. By contrast, multiple-advance closed-end credit is complicated, and can result in more TILA errors than we could explain in a novel.

9. Failing to accurately disclose the balance subject to a finance charge on periodic statements

Under TILA, creditors providing open-end credit must furnish consumers with a periodic statement that includes several key disclosures, including the balance on which the finance charge is computed. This disclosure includes the amount of the balance to which a periodic rate was applied, along with an explanation of how that balance was determined. When a balance is determined without first deducting all credits and payments made during the billing cycle, creditors must disclose this information to the consumer, along with the amount of the credits and payments. As an alternative for transactions that are not home-secured plans, creditors are permitted to identify the name of the balance computation method and provide a toll-free telephone number that will explain the balance computation method and how resulting interest charges were determined. Failing to accurately disclose the balance on which the creditor calculates the finance charge is a TILA violation that will result in penalties, and possible contract violations.

10. Using the wrong formulas on periodic statements

Creditors are required to comply with certain calculation formulas. In some instances, we’ve seen banks and credit unions use single payment formulas based on the number of days in a billing cycle, when they should have multiplied the periodic rate times the number of periods in a year (which can be daily times 365 or monthly times 12). Getting the multiplication formula wrong means that the product will be wrong. And that means, you’ll violate TILA, and could also violate the contract terms.

Cue your authors throwing a pencil over their shoulder, because that’s our list of Top 10 Material Violations under TILA. While it wasn’t particularly funny, and sure wouldn’t be if your institution faced these types of claims, we hope reading this can help your institution stay out of trouble with plaintiffs and regulators.

^[1] Justin B. Hosie is a partner and practice group leader at Hudson Cook, LLP, a nationwide law firm focused on compliance with consumer protection laws governing financial services. Justin provides day-to-day compliance advice on various laws including the Federal Truth-in-Lending Act. Among various publications, Justin is co-authoring the “Annual Percentage Rates” chapter of the forthcoming American Bar Association’s Truth in Lending Manual, 2023 edition. He is AV rated by Martindale Hubbell and is recognized in The Best Lawyers in America for Financial Services Regulation Law.

^[2] Cliff E. Cook is an Executive Consultant with Compliance Services Group. Cliff began his banking and compliance career in 1974, and has since been widely recognized by the Banking, Credit Union, Consumer Loan, Payday Loan, and Title Loan industries as an authoritative source for Truth-in-Lending Act compliance, with particular expertise in assisting lenders in complying with the Annual Percentage Rate requirements, as well as issues related to product development, loan agreements, loan origination systems, and loan servicing systems. Recently, Cliff has been assisting commercial lenders and law firms to comply with the new state-required commercial loan APR disclosures.

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