The following article is reprinted from Basis Points® , Vol. 2, Issue 5, Copyright © 2003, with the permission of CounselorLibrary.com, LLC. All Rights Reserved. Further reproduction is prohibited without permission.

In a well-reasoned opinion, a federal court decided that Section 501 of DIDMCA preempts a California requirement that lenders wait until the day before the security instrument is recorded to begin assessing interest. As a result, lenders may continue assessing interest on first lien mortgage loans from the date they disburse funds, and not from the date the deed of trust is recorded.

DIDMCA is an acronym for a federal statute called the Depository Institutions Deregulation and Monetary Control Act that was enacted back in 1980. At that time, mortgage interest rates were rising to remarkable levels. In many cases, normal market rates approached and or exceeded state usury rates. At the same time, the law restricted the rate that savings banks could offer depositors on their deposit accounts. As a result, savings banks (then the primary source of housing credit for consumers) could not compete with other financial institutions such as securities brokers who offered money market accounts with market interest rates. As a result, the savings banks had very little money to lend and when they had money to lend, they often faced usury limits that restricted their ability to make fixed and adjustable rate loans.

DIDMCA attacked this problem at both ends. First, it removed limits on the rates that savings banks could pay their depositors. From that point on, savings banks have been able to attract deposits by offering competitive rates. Second, it preempted any state law expressly limiting the rate of interest or the amount of interest on a first lien mortgage loan. In so doing, Congress made a specific finding that state usury laws had to be modified in order to establish a stable national financial system.

In order to get the law passed through the Senate, the bill had to include a window period for states to opt-out of the federal usury preemption. A number of states elected to opt out of the preemption, including Colorado, Hawaii, Idaho, Iowa, Kansas, Maine, Minnesota, Nebraska, Nevada, North Carolina, Puerto Rico, South Carolina, South Dakota and Wisconsin. In many of these states, the legislatures have exempted first lien mortgage loans from usury restrictions or increased their usury limits to levels that don't interfere with loan markets.

California did not opt out. In fact, California has always been viewed as one of the easier states to live with from a usury perspective. The rule in California is that, so long as you have an appropriate lending license or charter, you are exempt from the usury limits. So, most lenders have not really thought much about usury issues when making first lien loans in California. They figured that either they were exempt from the state usury restrictions under state law or they were entitled to federal usury preemption.

Then, one day, California regulators started kicking sand in lender's faces. The regulators pointed to a provision in the California Civil Code (Section 2948.5) that prohibits a lender from charging interest more than one day before the deed of trust is recorded. Up until then, the practice had been to start charging interest on the day funds were disbursed. However, in recent times, more than seven months have been known to pass between the day that a deed of trust is delivered to the recorder's office and when it actually gets recorded. Why so long? Who knows? But in order to make life simpler for borrowers, lenders have gone ahead and funded their loans before the deed of trust gets recorded. The California regulators rewarded lenders for taking the consumer-friendly step of funding their loans before they have a perfected security interest by ordering those same lenders to refund all interest that accrued before the deed of trust was recorded. If that makes any sense to you, you need a Mommy very, very badly.

Does the California law restrict the rate of interest or the amount of interest? Well, it clearly does not limit the rate of interest. Even in California, you can charge any rate you can get the borrower to agree to. Does it limit the amount of interest? If you fund a loan before you record the deed of trust it certainly does.

In reaching its conclusion, the court had to wrestle with an ugly precedent from the First Circuit Court of Appeals called Grunbeck v. Dime Savings. In Grunbeck, the promissory note provided for negative amortization. New Hampshire law prohibited negative amortization. The First Circuit decided that the state restriction did not limit the amount of interest the parties could set. According to that decision, the borrower and the lender could agree to any rate of interest or any amount of interest. The only thing state law prohibited was the compounding feature. So, the state law was not in conflict with Section 501.

The federal court sitting in California was aware of Grunbeck. It noted that the statute in Grunbeck simply limited the manner in which the interest was expressed and did not limit the amount of interest that could be collected over a given period. In contrast, California's per diem interest limitation prevents lenders from charging the amount of interest they want by tying the total amount of interest charged to events outside their control (when the deed of trust gets recorded).

The court avoided dealing with a second argument raised by the lender. For years now, case law in California has held that the Home Owners Loan Act (HOLA) preempts this Civil Code provision on when you can start charging interest from applying to federal savings banks. Quicken argued that the Alternative Mortgage Transactions Parity Act (AMTPA) gives it, as a state licensed mortgage banker, parity with federal savings banks when making alternative mortgage loans. To make a long story short, Quicken argued that if the Civil Code does not apply to a federal savings bank, then it does not apply to Quicken when it makes alternative mortgage loans under AMTPA. An intriguing argument, at least. But so far, not the law.

For more information, look for Quicken Loans, Inc. v. Boutris, No. CV S-03-0256 (E.D. Cal. May 8, 2003).

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