Disclosing Construction vs. Refinance Loans

This is a question I received recently, and I think it’s a situation that might not come up often enough to remember all the rules about it. So it’s always helpful to review.

Here’s the situation: A borrower comes to you and is seeking a loan to make major additions to their home. They have an existing home, so the original structure is there, but the new additions will be more than double the size of the home, and increase the value more than two times. You consider this to be a construction loan given the size of the project. It’s a 30 year loan with a one year interest only construction period.

Because there is an existing structure though, there is also an existing lien already on the property. Therefore, part of the loan, in addition to financing the construction of the addition to the home, will be used to pay-off and replace the existing loan.

How should you characterize this type of loan for TRID purposes? How is it disclosed?

First, it’s not a purchase transaction because the borrower has already purchased the existing structure on the property, so that’s already off the table. That’s a simple answer. So it comes down to construction, refinance, or home equity then.

Home equity is the catch-all for loans secured by the property but is not for the purpose of purchasing the property, constructing it, or refinancing an existing lien. If it doesn’t fit into one of those categories, it’s probably a home equity loan. But it’s preferred; it’s a fallback. So, unsurprisingly, it’s down to a construction or refinance loan.

It’s tempting to think this loan is a construction loan for TRID purposes. The work that will be done is extensive and worth more than the original property, the loan is more than twice the amount of the original lien, and the new loan is even structured with a 1 year interest-only payment period. For all intents and purposes, it looks like a construction loan, and maybe even internally you consider it to be a construction loan.

Be careful though. The definition of a construction loan is found in 12 C.F.R. § 1026.37(a)(9)(iii), and a significant part of the definition is that a construction loan is, for TRID purposes, only when the credit will be “used to finance the initial construction of a dwelling.” In our situation here then, the dwelling is already there; it’s just being massively updated. Therefore, because the loan is for additions to an already existing structure, it is not for financing the initial construction of a dwelling.

The loan is actually a refinancing then. There is an existing lien which will be “satisfied and replaced” by the permanent financing of the new loan, and this is an essential element for identifying refinancings.

This falls outside the normal situation for refinancings, so I understand any hesitation or uneasiness with calling the transaction a refinancing. But the definition of refinancing is broad, and only has a few elements to it. A refinancing must be 1) a new extension of credit, which will be used to 2) satisfy and replace an existing obligation, and 3) is secured by the subject property. That’s pretty much it. So even though this transaction might not be the typical refinancing transaction, it still falls under TRID’s refinancing definition.

Finally, don’t forget the priority order for TILA. If a transaction has multiple purposes, the preferred order is 1) Purchase, 2) Refinance, 3) Construction, and 4) Home Equity. So even if this transaction is both a construction and refinance transaction, refinance is preferred over construction, and therefore should be reported first.

This may be just a long-winded way of looking at the construction vs. refinancing rules, which you may already know quite well. But it doesn’t hurt to revisit the rules from time to time, especially when you have unconventional transactions come across your desk.