Capitalization of Unpaid Interest: A Letter to Credit Unions
Hello, this is Samantha Shares. This episode covers N C U A’s letter to credit unions number twenty three C U zero seven titled Capitalization of Unpaid Interest.
The following is an audio version of that letter. This podcast is educational and is not legal advice. We are sponsored by Credit Union Exam Solutions Incorporated, whose team has over two hundred and Forty years of National Credit Union Administration experience. We assist our clients with N C U A so they save time and money. If you are worried about a recent, upcoming or in process N C U A examination, reach out to learn how they can assist at Mark Treichel DOT COM. Also check out our other podcast called With Flying Colors where we provide tips on how to achieve success with N C U A.
While this letter is three years old it is still active and relevant. And now the letter.
Capitalization of Unpaid Interest
Dear Boards of Directors and Chief Executive Officers:
On June twenty-fourth twenty twenty one, the N C U A Board unanimously voted to lift the prohibition of capitalization of interest in connection with loan workouts and modifications from regulation. The rule became effective July thirtieth, twenty twenty one, and applies to loan workouts and modifications on or after this date. The rule establishes documentation requirements to help ensure that the addition of unpaid interest to the principal balance of a loan does not hinder the borrower’s ability to repay the loan.
For borrowers experiencing financial hardship, a prudently underwritten and appropriately managed loan modification, consistent with safe and sound lending practices, is generally in the long-term best interest of both the borrower and the credit union. Modification options include lowering of loan payments or the interest rate, extending the maturity date, partial principal or interest forgiveness, and capitalization of interest. Such modifications may allow a borrower to repay the loan, which helps the borrower and the credit union avoid the costs of default and foreclosure.
The final rule continues to prohibit credit unions from financing credit union fees and commissions. Credit unions will be permitted to continue to make advances to cover third-party fees to protect loan collateral, such as force-placed insurance or property taxes. Maintaining the prohibition on the capitalization of credit union fees is an important consumer protection feature of the rule for member borrowers.
Consumer Protection Considerations
The final rule requires credit unions to adopt policies and procedures to ensure that loan modifications are in the long-term best interest of the borrowers. All documentation, including required disclosures, must be accurate, clear and conspicuous, and consistent with applicable federal and state laws and regulations. Any adverse credit reporting must be accurate and comply with the requirements of the Fair Credit Reporting Act, and, when applicable, state law.
Credit Risk Considerations
This regulation applies to all consumer and commercial loans. Credit unions should document why capitalizing interest is the best course of action when determining the terms of the modification. Further, the rule requires the credit union’s policy ensure that a credit union makes loan workout decisions based on a borrower’s renewed willingness and ability to repay the loan.
A credit union’s policy must also establish limits on the number of modifications permitted for an individual loan. If a credit union restructures an individual loan more than once a year or twice in five years, examiners will expect the documentation to reflect the borrower’s continued willingness and ability to repay the loan.
The agency continues to encourage credit unions to work with their members who are experiencing financial difficulties due to the COVID-19 pandemic using safe and sound approaches. Therefore, the agency will not object to previous loan modifications, including interest capitalization, prior to the effective date of this rule change if such efforts are conducted in a reasonable manner with proper controls and management oversight.
Please contact your examiner, your regional office, or your state supervisory authority if you have questions. Next, we provide the question and answer portion of the letter.
Question and Answer
Question: what is required in a loan modification policy that permits capitalization of interest?
Answer: Prudent loan modification policies and procedures help borrowers resume affordable, sustainable payments by using an appropriate structure to meet the needs of the borrower while minimizing losses to the credit union.
Consistent with the final rule, the policy should have explicit language prohibiting the authorization of additional advances to finance credit union fees and commissions.
Procedures will include providing borrowers with written disclosures that are accurate, clear, and conspicuous in accordance with federal and state consumer protection laws and regulations. Additionally, policy and procedures will have standards for appropriate documentation that reflect a borrower’s ability to repay, a borrower’s source(s) of repayment, and when appropriate, compliance with the credit union’s valuation policies at the time the modification is approved.
Question: The updated regulation says if we capitalize interest we have to analyze whether the borrower has the ability to repay the debt. It sounds like we need to reunderwrite the loan. How does the credit union determine the ability to repay the debt?
Answer: There is no change to the requirement to document whether the borrower is able to repay the debt. The final rule does not prescribe a method for making that determination, as it provides flexibility to the credit union. However, the credit union should maintain documentation in the loan file reflecting how it made that determination, including evidence of the borrower’s source of income. We would expect this documentation to follow loan guidelines such as debt to income ratio or debt service coverage ratio, proof of income, budgets, and business projections, among other items as needed.
Question: What disclosures should a credit union provide a borrower for a loan modification that includes capitalized unpaid interest?
Answer: The final rule does not require the use of specific disclosures. However, Regulations X and Z may apply to some modifications, so a credit union must comply with the applicable disclosure and notice requirements of those regulations. The terms of the modification will dictate which, if any, disclosures or notices the credit union will provide. All disclosures and notices must be accurate, clear, and conspicuous.
Question: What methods are acceptable for capitalization of interest?
Answer: The following approaches, among others, may be acceptable:
Capitalization of deferred interest and adjusting monthly payments upward;
Capitalization of deferred interest and extending the loan term; or
Break out deferred interest into a separate note, provided collateral is adequate, or have an unsecured note as needed. The payments on the separate note may be concurrent or could be deferred until a future date, either specified or upon repayment of the primary note.
When choosing a method, the federally insured credit union should fully understand the implications for the various choices including, but not limited to:
Consistency with safe and sound credit underwriting standards;
Impacts on the timing of interest recognition;
Impacts on collateral coverage, including when a secured loan is extended beyond its original terms; and
Impacts on accrual status and potential cross-defaults when notes are bifurcated.
This concludes the NCUA Letter. If your Credit union could use assistance with your exam, reach out to Mark Treichel on LinkedIn, or at mark Treichel dot com. This is Samantha Shares and we Thank you for listening.
