Amendments to Real Estate Settlement Procedures Act Regulation (Regulation X)Escrow Accounting Procedures

SUMMARY: In this final rule, the Department of Housing and Urban

Development is revising Regulation X, which implements the Real Estate

Settlement Procedures Act of 1974 (RESPA). This rule addresses problems

that were raised in applying escrow accounting requirements under

Regulation X. The first problem, designated as ``Annual vs. Installment

Disbursements,'' involves whether disbursements from mortgage escrow

accounts must be made on an annual or installment basis when the payee

offers a choice. To address this problem, this rule maintains the

current requirements under Regulation X, but clarifies them.

The second problem, designated as ``Payment Shock,'' involves the

proper accounting method to calculate escrow payments where the

servicer anticipates that disbursements for items such as property

taxes will increase substantially in the second year of the escrow

account and where ``payment shock''--the consumer's experiencing of a

substantial rise in escrow payments--will result. The Department has

chosen to address this matter by recommending (but not mandating) a

best practice for servicers: a voluntary agreement to accept

overpayments. A consumer disclosure format has been provided to

disclose this information. This rule contains a new provision covering

procedures for voluntary overpayments.

The Department has determined not to adopt two other changes that

were proposed. The Department will continue to require the single-item

listing of escrow deposits on the HUD-1 or HUD-1A. Also, the Department

is not revising the requirements for listing a lead-based paint

inspection or risk assessment on the Good Faith Estimate (GFE) format

and HUD-1 and HUD-1A, but is clarifying the instructions for these

formats.

EFFECTIVE DATE: February 20, 1998.

FOR FURTHER INFORMATION CONTACT: David R. Williamson, Director, Office

of Consumer and Regulatory Affairs, Room 9146, or Rebecca J. Holtz,

Director, RESPA/ILS Division, telephone (202) 708-4560; or, for legal

questions, Kenneth A. Markison, Assistant General Counsel for GSE/

RESPA, Room 9262, telephone (202) 708-1550, or Grant Mitchell, Senior

Attorney for RESPA, telephone (202) 708-1552 (these are not toll-free

telephone numbers). For hearing-and speech-impaired persons, these

telephone numbers may be accessed via TTY (text telephone) by calling

the Federal Information Relay Service at (800) 877-8339 (toll-free).

The address for these persons is: Department of Housing and Urban

Development, 451 Seventh Street, SW, Washington, DC 20410-0500.

SUPPLEMENTARY INFORMATION:

I. Background

The Department's 1994-1995 escrow accounting rules 1

included significant new requirements for servicers maintaining an

estimated 35 million mortgage escrow accounts for American homeowners.

These rules, promulgated under the Real Estate Settlement Procedures

Act (RESPA) (12 U.S.C. 2601-2617), as amendments to Regulation X (24

CFR part 3500), limited the amounts that servicers may hold in escrow

accounts by establishing new uniform accounting and disbursement

requirements and by requiring meaningful disclosure to each homeowner

at the account's inception and annually thereafter.

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\1\ The Department issued several escrow rules during 1994-1995.

On October 26, 1994 (59 FR 53890), the Department published a final

rule implementing sections 6(g) and 10 of RESPA and changes to RESPA

made in section 942 of the Cranston-Gonzalez National Affordable

Housing Act (Pub. L. 101-625, approved November 28, 1990). Because

of the magnitude of the change brought about by this rule, soon

after its publication it became evident that further clarification

of the rule was needed. The Department issued a February 15, 1995

rule (60 FR 8812) that modified and clarified the October 1994 rule

and delayed its effective date until May 24, 1995. The Department

issued further rules to clarify and correct the October 1994 rule on

December 19, 1994 (50 FR 65442); March 1, 1995 (60 FR 11194); and

May 9, 1995 (60 FR 24734), and published a notice of software

availability on April 4, 1995 (60 FR 16985). These rules are

referred to in this preamble collectively as the 1994-1995 escrow

rules.

The Department's RESPA regulations were streamlined on March 26,

1996 (61 FR 13232) to comply with the President's regulatory reform

initiatives. On September 3, 1996 (61 FR 46510), the Department

published a correction to 24 CFR 3500.17. The Department published

further revisions to Regulation X on September 24, 1996 (61 FR

50208) and November 15, 1996 (61 FR 58472).

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The 1994-1995 escrow rules represented a notable achievement. As a

result of the escrow rules, the amounts in homeowners' escrow accounts

have been reduced substantially. At the time the rules were

promulgated, the Department estimated that homeowners would save as

much as $1.5 billion by virtue of the new rules. This savings is now

being used by homeowners for down payments, to keep and maintain homes,

or to fill other needs.

Because the 1994-1995 escrow rules implemented new accounting

requirements, they required major changes by mortgage servicers. As the

rule's requirements were applied to individual accounts, members of

Congress, local government officials, industry representatives, and

homeowners brought to the Department's attention certain problems

concerning the 1994-1995 rules. In this final rule, the Department is

clarifying the rules and identifying ``best practices'' 2 of

mortgage servicers in an effort to resolve two of these problems.

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\2\ Generally, the Department has characterized ``best

practices'' in other programs as those practices that are in

accordance with a law's purposes, that are widely replicable, that

show creativity in addressing a problem or problems, and that have a

significant positive impact on those whom they are intended to

serve. The Department identifies best practices operating

successfully in the marketplace that support the regulatory

principles involved in order to encourage their use. For example,

the Department has identified best practices in furtherance of its

responsibilities under the Fair Housing Act (42 U.S.C. 3601 et

seq.).

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As detailed below, the first problem, designated as ``Annual vs.

Installment Disbursements,'' is whether disbursements from mortgage

escrow accounts should be made on an annual or installment basis if the

payee offers a choice. In some cases, a switch from installment to

annual disbursements, required under certain circumstances under the

rule, resulted in servicers requiring greater payments to escrow

accounts for some borrowers and adverse tax consequences for some

borrowers. The second problem, designated as ``Payment Shock,'' was

asserted to occur when borrowers were required to make significantly

increased payments into their escrow accounts when disbursements for

items such as property taxes would increase substantially in the second

year of the escrow account and the rule did not allow servicers to

require escrowing for the next year's payments. The Department also

became aware of two additional concerns involving the disclosure of

amounts required for escrow using single-item accounting and involving

the possible need for a new disclosure of lead-based paint inspection

fees.

All of these matters led the Department to issue a proposed rule on

September 3, 1996 (61 FR 46511) to seek public comment on these issues.

In the

[[Page 3215]]

proposed rule, the Department offered a variety of approaches to

address these matters in the most economical and efficient way. The

Department recognized that the rules were new and industry and consumer

adjustments were underway. Consequently, the choices included keeping

the requirements the same, but clarifying them, or doing nothing.

In the Department's proposal, the Secretary pointed out that any

amendments to the rule must further the following three principles:

(1) Reduce the cost of homeownership by ensuring that funds are not

held in escrow accounts in excess of the amounts that are necessary to

pay expenses for the mortgaged property and allowed by law;

(2) Establish reasonable, uniform practices for escrow accounting;

and

(3) Provide servicers with clear, specific guidance on the

requirements of section 10 of the Real Estate Settlement Procedures Act

of 1974 (RESPA), which governs escrow accounting procedures.

Following receipt of comments under the proposed rule, as detailed

below, the Department determined that many of the initial problems in

implementing the escrow rules were being resolved as the industry and

the public adjusted to the new requirements. Specifically with respect

to the choice of annual vs. installment disbursements, consumers'

accounts that had been changed as a result of the implementation of the

rule had stabilized and had not been changed again. However, there

remains a need for the Department to clarify and elucidate current

requirements in this final rule.

With regard to the ``payment shock'' problem, the Department

determined, based on the comments, that extensive additional regulatory

changes are not required and could prove detrimental to consumers.

Instead, the Department determined that this problem would be better

resolved by identifying and sharing best practices of servicers. In

this context, servicers should, as a best practice, provide a simple

notice to consumers to allow them voluntarily to increase their

payments to their accounts. A new provision in 24 CFR

3500.17(f)(2)(iii) sets forth procedures if voluntary overpayment

agreements are obtained.

The Department also determined not to adopt other changes to the

Good Faith Estimate (GFE), HUD-1, and HUD-1A that were proposed to

address the other matters raised in the proposed rule. Based on the

comments received, the Department determined that new requirements on

these subjects were not necessary. Current disclosure requirements are

generally useful and sufficient; more significant changes at this time

could serve to confuse matters while the market is still adjusting to

the relatively new rules. Moreover, the Department has recently issued

a new settlement booklet for consumers entitled ``Buying Your Home,

Settlement Costs and Helpful Information,'' published on June 11, 1997

(62 FR 31982), which includes guidance on lead inspections during the

homebuying process. To complement these new materials, the Department

is making one minor clarification to the instructions for the HUD-1

regarding lead-based paint disclosures.

In sum, the regulatory record, described in detail below, makes

very clear that this subject involves complex matters that in many

cases are better resolved by allowing time for accounting systems and

consumers alike to adjust. In this final rule, the Department continues

to protect homeowners by maintaining escrow accounting requirements and

limits without change. At the same time, in the interest of reducing

homeownership costs, establishing uniform practices, and providing

clear specific guidance, the rule makes modest clarifications to ensure

that servicers do not unnecessarily incur additional costs that would

ultimately be passed on to American homeowners.

In applying the significant protections under RESPA--including the

limits on the amounts in mortgage escrow accounts--the Department is

mindful that it must carry out RESPA's important requirements in a

manner that is true to RESPA's consumer protection purposes. These

purposes include ensuring that consumers are protected from

unnecessarily high costs that may come from abusive practices by

servicers.

This preamble continues with a background discussion of the legal

requirements under section 10 of RESPA and the Department's prior

rulemakings. Following the background discussion, the preamble

discusses the issues addressed in the proposed rule and details the

many comments received on the proposed rule. These comments informed

the Department and shaped today's rule. Finally, the preamble discusses

this final rule.

II. Legal Context

Section 10 of RESPA (12 U.S.C. 2609) establishes the statutory

limits on the amounts that mortgage servicers or lenders may require a

borrower to deposit into an escrow account if the mortgage documents

require one or the servicer chooses to establish one.3 RESPA

does not require the use of escrow accounts. Section 10(a)(1) of RESPA

does prohibit a servicer, at the time the escrow account is created,

from requiring the borrower to make a payment to the escrow account in

excess of the maximum amounts calculated in accordance with the

statute. These maximum amounts are calculated by analyzing how much

money will be needed to cover expected disbursements, such as taxes and

insurance, ``beginning on the last date on which each such charge would

have been paid under the normal lending practice of the lender and

local custom, provided that the selection of each such date constitutes

prudent lending practice, and ending on the due date of the first full

installment payment under the mortgage'' relating to the mortgaged

property, plus a cushion no greater than one-sixth of the estimated

total annual disbursements from the account (one-sixth cushion).

Section 10(a)(2) prohibits the lender, over the rest of the life of the

escrow account, from requiring the borrower to make payments to the

escrow account that exceed one-twelfth of the total annual escrow

disbursements that the lender reasonably anticipates paying from the

escrow account during the year, plus the amount necessary to maintain a

one-sixth cushion. Section 10 does not require that the servicer

collect the maximums allowed under the statute; the servicer may always

collect less and is not required to collect any cushion at all.

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\3\ As stated in footnote 1 to the preamble to the Department's

September 3, 1996 proposed rule on escrow accounting (61 FR 46511,

46511 n.1), at times RESPA uses the term ``lender'' and at other

times it uses the term ``servicer.'' A lender creates a loan

obligation, but may or may not service the loan. As in the proposed

rule, within this final rule the Department uses the term

``servicer'' to include the lender when the lender performs the

servicing function.

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Section 10 and section 6(g) of RESPA (12 U.S.C. 2605(g)) govern the

timing of disbursements from escrow accounts. In choosing a

disbursement date, section 10 requires that the servicer follow

``normal lending practices of the lender and local custom, provided

that the selection of each such date constitutes prudent lending

practice.'' Section 6(g) requires servicers to ``make payments from the

escrow account for such taxes, insurance premiums, and other charges in

a timely manner as such payments become due.''

[[Page 3216]]

III. Explanation of Problems Addressed in September 3, 1996

Proposed Rule and Proposed Solutions

On September 3, 1996 (61 FR 46511), the Department published a

proposed rule, primarily to address three problems in implementing the

1994-1995 escrow rules. These problems, explained below, were

designated as:

Annual vs. Installment Disbursements;

Payment Shock; and

Single-item Analysis with Aggregate Adjustment.

In addition, the Department proposed revising the GFE format and

HUD-1 and HUD-1A to refer specifically to a lead-based paint inspection

or risk assessment.

A. Annual vs. Installment Disbursements Problem

1. Explanation of the Annual vs. Installment Disbursements Problem

The first problem that the proposed rule addressed involved the

servicers' disbursements from mortgage escrow accounts if the payee

(i.e., the entity to which escrow disbursements are paid, such as a

taxing jurisdiction) offers a choice of disbursements on an annual or

installment basis. Sometimes payees offer a discount to the borrower if

disbursements are made on an annual basis. These discounts are commonly

offered by taxing jurisdictions, which may offer a discount for annual

payments of property taxes.

The Department's regulation at 24 CFR 3500.17(k)(1) has provided,

``In calculating the disbursement date, the servicer shall use a date

on or before the earlier of the deadline to take advantage of

discounts, if available, or the deadline to avoid a penalty.'' See also

Secs. 3500.17(b) (definition of ``disbursement date''); 3500.17(c)(2)

and (c)(3); and 3500.17(d)(1)(i)(A) and (2)(i)(A). The preamble to the

October 1994 final rule explained, ``Unless there is a discount to the

borrower for early payments, the regulation does not allow servicers to

pay installment payments on an annual or other prepayment basis.'' 59

FR 53893. The preamble explained that this approach is consistent with

the Department's intention that the regulations generally favor

installment disbursements, because in many cases they result in lower

up-front payments (closing costs). The Department also sought for

servicers to take advantage of discounts that would benefit borrowers.

In response to further questions on this issue, however, the

Department indicated in its February 1995 final rule clarifying the

escrow rules that the October 1994 rule's focus had been to address ``a

practice, previously engaged in by some servicers, of collecting and

paying a full-year's taxes in advance, although they were billed on an

installment basis.'' 59 FR 8813. In the preamble to a May 1995 further

clarification to the rules, the Department stated that ``servicers were

permitted (but not required) to make disbursements on an annual basis

if a discount were available.'' The preamble to the May 1995 rule

explained:

[T]he Department received a number of questions regarding

circumstances in which the payee offered an option of either

installment payments or a one-time payment with a discount. The

preamble to the October 26, 1994, and February 15, 1995, rules

indicated that when a choice was available, servicers should make

disbursements on an installment basis, rather than an annual basis;

however, servicers were permitted (but not required) to make

disbursements on an annual basis if a discount were available. Once

the choice of payment basis is made, the disbursement date chosen

for that basis depends on discount and penalty dates. Section

3500.17(k) states that ``[i]n calculating the disbursement date, the

servicer shall use a date on or before the earlier of the deadline

to take advantage of discounts, if available, or the deadline to

avoid a penalty.'' This provision is consistent with the rule, which

is designed to avoid excessive upfront payments and balances in

escrow accounts and, therefore, favors installment payments, unless

there are penalties or discounts that make annual payments

advantageous for the consumer. Also, after settlement a servicer and

borrower are not prevented by this rule from mutually agreeing, on

an individual case basis, to a different payment basis (installment

or annual) or disbursement date.

60 FR 24734.

In the preamble to the September 3, 1996 proposed rule, the

Department indicated that the rule text and the preamble language may

have created confusion. As explained in the preamble to the proposed

rule, some mortgage servicers have interpreted the rule to require that

a servicer, when offered an option of making a disbursement from the

escrow account in installments or in an annual disbursement with a

discount, must choose the lump sum annual disbursement with a discount,

no matter how small the discount is, even if the borrower and the

servicer would otherwise agree to forego the discount and have the

escrow account computed for disbursements on an installment basis. On

the other hand, other servicers have interpreted the Department's rule,

in light of preamble language, to require installments when available

and allow, but not require, annual disbursement at the servicer's

discretion when a discount is offered for annual disbursement.

As indicated in the preamble to the proposed rule, some borrowers

were affected by the changes brought about by the 1994-1995 escrow

rules. Concerns raised to the Department regarding the annual vs.

installment disbursements problem came from borrowers and members of

Congress who were concerned about the effect of the 1994-1995 escrow

rules on their constituents.

As explained in the preamble to the proposed rule, the choice of

disbursement methods has consequences for borrowers, including

increasing or decreasing the amounts required to be deposited into the

escrow account at closing. In general, disbursements from an escrow

account in installments work to the borrower's benefit, because, on

average, they result in lower up-front payments to establish the

account (i.e., lower closing costs). Footnote 2 of the proposed rule

(61 FR 46512) explained:

The choice of installment, rather than annual, disbursements

often results in substantial reductions in up-front cash

requirements for the buyer. For example, if two equal installments

could be paid 6 months apart instead of paying the entire bill on

one of the installment dates, then homebuyers who close on their

loans less than 6 months before the date on which the entire bill

would otherwise have been due could come to settlement with 6 months

less in tax deposits to the escrow account. This results from the

accrued taxes being a half-year's taxes less for those homebuyers.

Assuming closings are evenly distributed throughout the year,

households with the option of two equal installment payments 6

months apart, will, on average, be able to reduce the average up-

front cash required at settlement by 3-months' worth of taxes. In

general, as the number of installments grows, so does the average

up-front savings.

The disbursement method may also have income tax ramifications for the

consumer, depending on the timing of disbursements for deductible

items.

The preamble to the proposed rule explained that after publication

of the 1994-1995 escrow rules, many servicers that had been disbursing

in installments switched to annual disbursements if discounts were

available. There were many consequences of the switch that have been

described to the Department, mostly affecting borrowers, and other

consequences that the Department speculates may have resulted. After

the Department issued the escrow rule, some borrowers may have been

required by their servicers to make up substantial shortages in their

escrow accounts (generally in increased monthly payments over a year),

which arose

[[Page 3217]]

when taxes were switched from installment disbursements to one annual

lump sum disbursement.

The preamble to the proposed rule also noted other adverse

consequences that might have arisen from the 1994-1995 escrow rules.

For example, some borrowers whose servicers switched from annual to

installment disbursements may have lost a significant portion of their

income tax deductions for property taxes in the year in which the

switch was made and may have been unhappy with that consequence. Some

taxing jurisdictions may have faced an unexpected temporary shortfall

in receipts of property taxes as a result of servicers changing from

annual to installment disbursements.

The preamble to the proposed rule also noted that although some

borrowers may have been adversely affected by a change in disbursement

method, many others likely benefited, perhaps unknowingly, from such a

change. For example, a change from installment to annual disbursements

to take advantage of a discount lowered the total tax burden for many

homeowners. Similarly, a change from annual to installment

disbursements resulted in lower escrow payments and, possibly, refunds

or credits for many homeowners. Finally, for many borrowers, the

Department's rules apparently have not resulted in any change to the

disbursement method for their escrow accounts.

2. Alternatives Proposed to Address Annual vs. Installment

Disbursements Problem

In response to the Annual vs. Installment Disbursements problem,

the Department proposed alternative ways of revising the escrow rules,

including requiring that disclosures be given to borrowers so that they

could make informed choices as to how their accounts were to be set up

and maintained and require servicers to follow those preferences. At

the same time, the Department recognized that providing borrowers

choices may impose additional burdens and costs on servicers, which are

frequently passed on to borrowers. Thus, the proposed rule also

highlighted approaches that had been proposed by industry

representatives. The Department sought comments on all approaches and

also asked a number of questions that were designed to help the

Department make decisions among alternatives for the final rule.

a. Consumer Choice. The first alternative contained in the proposed

rule, Consumer Choice, distinguished between new loans and existing

loans. Under this alternative, for new loans (loans that settled on or

after the effective date of a final rule), servicers would be required

to give borrowers the choice of making disbursements of property taxes

on an installment or on an annual basis, when those options are offered

by the taxing jurisdiction. The Department's proposal did not address

the choice between installments and annual disbursements for other

escrow items, because the question has only been raised to the

Department in the context of property taxes. The preamble indicated

that the Department would consider addressing other escrow items,

depending on comments received.4

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\4\ The preamble to the proposed rule noted that if the servicer

is given a choice between installment or annual disbursements for

other escrow items (such as property or hazard insurance), the

Department's rule would require the servicer to make disbursements

by a date that avoids a penalty, but the servicer would otherwise be

free to make disbursements on such date as complies with normal

lending practice of the lender and local custom, provided that the

selection of each such date constitutes prudent lending practice.

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This alternative would have required servicers, at some time before

settlement, to provide a disclosure, in the format of Appendix F in the

proposed rule, to borrowers whose property taxes will be paid from an

escrow account and whose taxing jurisdictions offer the choice between

disbursements on an installment or an annual basis. The proposed format

indicated some of the advantages and disadvantages to the borrower of

installment and annual disbursements and asked the borrower to make a

choice between the methods. The preamble explained that if the borrower

did not make a choice, the servicer would be required to make

installment disbursements of property taxes. As discussed below, this

alternative also would have provided that once the consumer had made a

choice (or installments were required because the consumer did not make

a choice), the servicer and subsequent servicers would be prohibited

from changing the method of disbursement for property taxes without the

borrower's prior written consent, as long as the taxing jurisdiction

continued to offer a choice.

For existing loans (loans that were settled prior to the effective

date of a final rule), this alternative would have prohibited the

servicer and subsequent servicers from changing the method of

disbursement for property taxes without the borrower's prior written

consent where the taxing jurisdiction offers a choice between

installments and annual disbursements. In addition, no later than the

first escrow analysis for such escrow accounts performed after the

effective date of a final rule, servicers would be required to offer

borrowers, in writing, an opportunity to switch from one method of

disbursement for property taxes to another.

b. Servicer Flexibility. Under the second alternative presented in

the proposed rule, the Department would have revised the rule to

provide that a servicer must make disbursements by a date that avoids a

penalty, but the servicer is otherwise free to make disbursements on

such date as complies with normal lending practice of the lender and

local custom, provided that the selection of each such date constitutes

prudent lending practice. As discussed below, under this alternative,

once the servicer had made a choice of the disbursement method, the

servicer and subsequent servicers would have been prohibited from

changing the method of disbursement without the borrower's prior

written consent, as long as the payee continued to offer a choice.

c. Keep, But Clarify, Current Requirements. The third alternative

offered in the proposed rule was that the Department would revise the

rule to keep, but clarify the current requirements. Under this

alternative, the regulations would have been revised to provide that

servicers must make disbursements from escrow accounts on an

installment basis, if payees offer that option as an alternative to

annual disbursements. If a payee offers the option of installment

disbursements or a discount for annual disbursements, however, the

servicer may, at the servicer's discretion (but is not required by

RESPA to), make annual disbursements, in order to take advantage of the

discount for the borrower; the Department encourages (but does not

require) servicers to follow the preference of the borrower. If the

payee offers the option of installment disbursements or annual

disbursements with no discount, the servicer must make installment

disbursements.

d. Prohibition Against Switching Disbursement Methods Without

Borrower's Consent. Each of the alternatives proposed--Consumer Choice;

Servicer Flexibility; and Keep, But Clarify, Current Requirements--

provided that once a disbursement method has been selected in

accordance with the requirements of the alternative, servicers would be

prohibited from switching disbursement methods without the borrower's

consent. This would mean that even if one servicer acquires servicing

from another servicer, the second servicer would be required to apply

the same disbursement method as the first servicer, as long as that

[[Page 3218]]

option is offered by the payee, unless the borrower consents to

changing disbursement methods.

The preamble to the proposed rule explained that the reason for

this approach was that many loans shifted disbursement dates as a

result of the 1994-1995 escrow rules. The Department was seeking to

develop an approach with the minimum negative impact for borrowers,

servicers, and third parties, such as taxing jurisdictions.

The preamble to the proposed rule explained the adverse

consequences, discussed above, that can occur when borrowers'

disbursement methods are switched. The preamble to the proposed rule

explained that the approach of prohibiting a servicer from switching

disbursement methods without the borrower's consent, including

requiring a servicer to use the disbursement method used by the former

servicer when there is a transfer of servicing, would not mean that the

borrower would have to consent to a transfer of servicing or would have

veto authority over such a transfer. However, this approach would mean

that a borrower would have to consent to a change in the disbursement

method, including a change proposed by a subsequent servicer. The

Department sought comments on whether this policy would adversely

affect the value, and the efficiency of the transfer, of servicing

rights.

B. Payment Shock Problem

1. Explanation of Payment Shock Problem

The second problem that the proposed rule addressed involved cases

in which the originator or servicer 5 anticipates that

disbursements for escrow items such as property taxes will increase

substantially in the second year of the escrow account. A substantial

increase in property taxes in the second year often occurs in cases of

new construction. In many jurisdictions, the taxes the locality charges

for the first year are based on the assessed value of the unimproved

property, while for the second year the taxes are based on the improved

value. A substantial increase in payments may also occur when a tax

disbursement that would normally appear on the projection for the

coming year is paid prior to the borrower's first regular payment,

i.e., these regularly occurring taxes do not appear in the projection.

Reassessments after a property is sold may also cause a substantial

second year increase.

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\5\ Three originators/servicers criticized the Department's

proposed rule because it identified the ``servicer'' as the person

who would be in a position to determine whether the bills paid out

of the escrow account will increase substantially after the first

year. These commenters indicated that it is the originator (loan

officer, processor, settlement agent) who communicates with

borrowers prior to closing, not the servicer, and that it should be

the originators who would be in the position of determining at

closing whether payments will substantially increase, not the

servicer. The Department intended to use the terms interchangeably

and explained in footnote 1 of the proposed rule (61 FR 46511) that

the term ``servicer'' included the lender when the lender performs

the servicing functions. The Department intended that the term

``servicer'' also would include the originator in this context.

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The preamble to the proposed rule explained that, consistent with

section 10 of RESPA, the Department's regulations have specified the

maximum amount that a servicer may legally require borrowers to deposit

in escrow accounts at the creation of the escrow account and during the

life of the escrow account. The Department's regulations prescribe that

in conducting an escrow account analysis, the servicer considers only

the disbursements that are expected to come due during the next 12-

month period. See Secs. 3500.17(b) (definition of ``escrow account

computation year'') and 3500.17(c) (limits on payments to escrow

accounts). While the servicer can take into account expected changes to

disbursements over the 12-month period,6 even if the

servicer knows that disbursements from an escrow account will

substantially increase at a time more than 12 months in the future, the

servicer cannot, when preparing the initial escrow account statement,

calculate the borrower's payments to cover the expected increases

beyond that 12-month period.

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\6\ The preamble to the proposed rule (61 FR 46511, 46516 n.7)

explained that the Department's current regulations address the

issue of estimating disbursement amounts for the 12-month

computation year:

To conduct an escrow account analysis, the servicer shall

estimate the amount of escrow account items to be disbursed. If the

servicer knows the charge for an escrow item in the next computation

year, then the servicer shall use that amount in estimating

disbursement amounts. If the charge is unknown to the servicer, the

servicer may base the estimate on the preceding year's charge as

modified by an amount not exceeding the most recent year's change in

the national Consumer Price Index for all urban consumers (CPI, all

items). In cases of unassessed new construction, the servicer may

base an estimate on the assessment of comparable residential

property in the market area.

24 CFR 3500.17(c)(7).

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However, the Department's existing regulations

(Sec. 3500.17(f)(1)(ii)) allow the servicer to conduct escrow account

analyses at other times during the escrow computation year, which can

result in changes to what the borrower must deposit in the escrow

account. Some servicers conduct escrow account analyses when bills for

escrow items increase.

Since the Department's current escrow rule provides for calculating

escrow payments based on the projection of escrow disbursements for a

12-month period, when escrow items increase substantially after the

initial 12-month period, the result is likely to be a substantial

increase in a borrower's monthly payments for the second year and/or a

lump sum payment, not only to reflect the higher disbursements, but to

make up a shortage in the escrow account.7 While the

originator or servicer could alert the borrower at closing that an

increase will occur, if that is not done, the borrower may be

unpleasantly surprised by the increase. The preamble to the proposed

rule explained that this situation could result in several problems.

While disclosures received at closing show low payment amounts

throughout the first year, the escrow payment will substantially

increase for the second year, or even during the first year if a short-

year statement is issued at the point when the higher disbursement

shows up in the 12-month projection.8 Some borrowers may be

unable to meet the increased escrow payments and paying off the

shortage will raise payments even more. A customer relations issue may

be created for servicers who have to explain to borrowers why the

payment is increased so much.

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\7\ The preamble to the proposed rule explained that an increase

in the monthly payment can be broken down into two components. Any

time an escrow account disbursement increases, it will have the

effect of raising the monthly borrower escrow payment by

approximately one-twelfth of that increase. In addition, the

projection for the coming year shows what the target balance

(accruals plus the cushion) should be at the beginning of the coming

year. To the extent that expected disbursements in the second year

exceed what they were in the first, the beginning target balance for

the second year may be in excess of the actual balance at the end of

the first year. If so, then there is a shortage to be made up as

well. If the 12-month approach is taken to eliminate the shortage,

then monthly payments will also rise by approximately one-twelfth of

the shortage. If a cushion is used, the payment increases will be

slightly higher, until the cushion is built up.

\8\ The Department's regulations at 24 CFR 3500.17(f)(1) (i) and

(ii) provide that, aside from conducting an escrow account analysis

when an escrow account is established and at completion of the

escrow account computation year, a servicer may conduct an escrow

account analysis at other times. The escrow account analyses

conducted at other times result in short-year statements.

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As indicated in the preamble to the proposed rule, the concerns

raised to the Department regarding payment shock came largely from

industry representatives who told the Department that they have had to

respond to numerous borrower inquiries

[[Page 3219]]

and complaints about increases in escrow payments to reflect higher

disbursements and payments to make up shortages. Mortgage servicers had

indicated that they wanted to avoid any payment change in subsequent

years by collecting more money in the first year of servicing.

2. Alternatives Proposed to Address Payment Shock Problem

The proposed rule offered three rulemaking alternatives, some of

which contained variations within the alternative, to address the

payment shock problem. The purpose of the alternatives was to develop a

consumer-friendly way to avoid the payment shock surprise for the

borrower, who may not be prepared to make the higher payments to his or

her escrow account that would result from a substantial increase in the

amounts needed for disbursements from the account. At the same time,

the proposals sought to minimize the burden on the industry.

a. Consumer Choice. The first alternative contained in the

proposed rule, Consumer Choice, would have provided that when the

servicer expected that the bills disbursed from the escrow account

would increase substantially after the first year, the servicer would

provide to the borrower, at some time prior to closing, a written

disclosure. The proposed format for the disclosure was set forth in

Appendix G to the proposed rule. The borrower would make a choice from

several accounting options for his or her account on a format that

would indicate, under each option: (1) the amount due at closing; (2)

the monthly escrow payments in the first, second, and third years; and

(3) the corresponding surpluses anticipated at the end of the first

year.9

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\9\ The preamble to the proposed rule noted that whether

disbursements from escrow accounts would be made on an annual or

installment basis and whether there were a discount for annual

disbursement would affect the numbers to be filled in and,

potentially, the number of calculations on the Escrow Accounting

Method Selection Format.

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The proposed rule explained that the borrower would, therefore,

have the opportunity to make a voluntary choice to limit payment

changes in the second year of the escrow account. As would be explained

on the disclosure format, if the borrower did not make a choice, the

accounting method would ``default'' to the method prescribed under the

current regulations (which may result in substantially increased

payments in the second year). This alternative, as proposed, contained

the additional restriction that once an escrow accounting method was

selected by choice or default, that method could not be changed without

the consent of the borrower, even if the servicing rights were

transferred to another servicer.

The preamble to the proposed rule explained that, under this

alternative, the following accounting methods (illustrated in ``The

Payment Shock Problem,'' Appendix H-1 to the proposed rule) would be

presented to the borrower for his or her selection:

Method A. Analysis of the account using the accounting method

required under the current rule, which results in a shortage at the end

of the first year and higher payments in the second year.

Method B. Analysis of the account using an accounting method that:

--Requires an initial deposit of $0 into the escrow account at closing;

--Requires a monthly payment in the first year equal to one-twelfth of

the estimated total annual disbursements from the escrow account for

the second year; and

--Causes surpluses or smaller shortages at the end of the first year,

which causes escrow payments to increase in the second year by an

amount less than under Method A or not at all.

Method C. Analysis of the account using an alternative accounting

method that:

--Requires an initial deposit into the escrow account at closing

greater than the initial deposits required under Method B;

--Requires the same monthly payment during the first year as under

Method B, which is greater than under Method A;

--Generates month-end balances such that the lowest month-end balance

for the first year equals one-sixth of the estimated total annual

disbursements for the second year (the initial deposit is not

considered in finding the lowest month-end balance);

--Generates even larger balances at the end of the first year than

under Method B, eliminating shortages and increasing surpluses that

must be returned to the borrower; and

--Causes no increase in escrow payments in the second year.

The preamble to the proposed rule noted that if the consumer were

to select Methods B or C, the amounts held in escrow could be greater

than allowed under section 10 of RESPA. In order to permit these

options, the Secretary would invoke his exemption authority under

section 19(a) of RESPA (12 U.S.C. 2617).

b. Make No Change. The second alternative in the proposed rule was

to continue the current requirements for escrow analysis, even when the

servicer expected that the bills disbursed from the escrow account

would increase substantially after the first year. This alternative

would not prevent payment shock in all instances. However, under this

alternative, servicers could continue to disclose voluntarily the

problem to borrowers and borrowers could make voluntary overpayments to

escrow accounts. Servicers could also calculate short-year statements.

Thus, even if no change were made to the regulations, some methods

would continue to be available, although not required, to alleviate the

payment shock problem.

c. Mandate First Year Overpayment. Under the third alternative in

the proposed rule, Mandate First Year Overpayment, the Department would

have provided that when the servicer expected that the bills disbursed

from the escrow account would increase substantially after the first

year, the servicer would be required to establish the escrow account

under a procedure that had the characteristics described under Consumer

Choice, Method C, above (illustrated in ``The Payment Shock Problem,''

Appendix H-2 to the proposed rule). The preamble to the proposed rule

explained that this approach would result in requiring amounts held in

escrow to be greater than allowed under section 10 of RESPA. The

Secretary could, however, mandate the use of this escrow accounting

method pursuant to his exemption authority under section 19(a) of RESPA

(12 U.S.C. 2617).

C. Single-Item Analysis With Aggregate Adjustment Problem

1. Explanation of Single-Item Analysis With Aggregate Adjustment

Problem

A third problem that the proposed rule addressed was the means of

disclosure on the HUD-1 and HUD-1A settlement forms of amounts required

for deposit at settlement in the escrow account. The 1994-1995 escrow

rules established aggregate accounting (i.e., analyzing the escrow

account as a whole) as the uniform nationwide standard escrow

accounting method to be used to compute borrowers' escrow accounts. In

establishing this standard, the rules supplanted single-item

accounting, the accounting method that had been used at settlement up

until that time to compute required escrow account balances.

Historically, under single-item accounting, the reserve amount for each

escrow account item on the HUD-1 or HUD-1A in the 1000 series was

computed for the borrower and listed separately. Either zero, one, or

two months worth of payments for

[[Page 3220]]

each escrow item was set forth on the HUD-1 or HUD-1A in the 1000

series as necessary to establish the escrow account.

When the Department was developing the 1994-1995 escrow rules,

Federal Reserve Board staff indicated that even if aggregate accounting

were used it also needed a single-item amount for private mortgage

insurance (PMI) reserves in order to make annual percentage rate (APR)

calculations under the Truth in Lending Act (TILA). For this reason,

and in an effort to avoid altering the basic format of the HUD-1 or

HUD-1A in the 1994-1995 escrow rules, the Department required that an

aggregate adjustment (either zero or a negative number) be made after

all of the individual items were listed separately in the 1000 series,

so that the total amount for escrow account items conformed to the

aggregate accounting method. Before the 1994-1995 escrow rules, Section

L of the HUD-1 and HUD-1A only showed positive numbers, that is,

payments that were being allocated to various settlement costs. After

publication of the 1994-1995 escrow rules, the Department received

complaints that the itemization of the reserve amounts with an

aggregate adjustment was confusing and the information was not useful

to borrowers. Settlement agents and others indicated that individual

itemization of reserves in the 1000 series imposed an additional

paperwork and explanation burden, when the only relevant number for

calculations is the total deposited.

2. Revision Proposed to Address Single-Item Analysis With Aggregate

Adjustment Problem

In response to the Single-Item Analysis with Aggregate Adjustment

problem the Department proposed to make more flexible the requirements

for the provision of information to consumers. In the proposed rule,

the Department proposed that to relieve confusion it would no longer

require the single-item listing of escrow deposits or reserves on the

HUD-1 or HUD-1A. The rule would create a new option in the instructions

for the 1000 series of these forms to reflect the aggregate amounts to

be deposited. As proposed, the settlement agent could also have

continued to itemize the 1000-series reserves, at the settlement

agent's discretion. If the charges were not itemized, an asterisk (*)

would have had to be placed next to each item in the 1000 series for

which a reserve was taken. The amount collected would have been

described as ``Aggregate Escrow Deposit for Items Marked (*) Above'' on

a line at the end of the 1000 series. In the discussion

``Clarifications of Existing Rule'' in Part VI of the preamble to the

proposed rule, the Department had clarified that entries on the GFE may

be based on single-item analysis, with a maximum 1-month cushion. The

proposed rule also clarified that the use of the estimating method

remained available after the end of the phase-in period (October 24,

1997).

D. Lead-Based Paint Disclosure Issue

1. Explanation of Lead-Based Paint Disclosure Issue

The proposed rule also addressed a concern that consumers should

get information about their right to arrange for a timely paint

inspection or risk assessment for the presence of lead-based paint or

lead-based paint hazards before becoming obligated under a sales

contract. The preamble to the proposed rule explained that a

prospective purchaser generally has 10 days to conduct such a lead-

based paint evaluation of the property. A prospective purchaser,

however, may waive in writing the opportunity to conduct this

evaluation. The proposed rule addressed ways that consumers could

receive this information in addition to existing disclosure

requirements.

2. Revision Proposed to Address Lead-Based Paint Disclosure Issue

In response to the Lead-based Paint Disclosure issue, the

Department proposed to require additional information to be provided to

the consumer on the GFE and the HUD-1 or HUD-1A. The Department

proposed to add information to the GFE format to help make purchasers

of pre-1978 residential dwellings aware that, pursuant to 42 U.S.C.

4852d (implemented by the Department in regulations published on March

6, 1996, 61 FR 9064), purchasers have the right to arrange for a paint

inspection or risk assessment for the presence of lead-based paint or

lead-based paint hazards before becoming obligated under a sales

contract. The Department proposed to add language to the GFE format

(Appendix C to part 3500) specifically to refer to a lead-based paint

inspection or risk assessment and designate a separate line in the 1300

series of the HUD-1 and HUD-1A for lead-based paint inspections or

assessments and to revise the instructions for completing the HUD-1 and

HUD-1A accordingly. The preamble to the proposed rule indicated that

the Department anticipated that a more detailed explanation of

purchasers' rights in this regard would be contained in the next

revision of the HUD Settlement Costs booklet. See section 5 of RESPA

(12 U.S.C. 2604); 24 CFR 3500.6.

IV. Overview of Public Comments

A. Description of the Commenters

The Department received a total of 141 comments on the proposed

rule. Of the 141 comments, some were duplicates. Thus, the Department

places the number of different comments received at 134.10

The Department analyzed all the comments in detail and gave them

careful consideration.

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\10\ Seven comments were identical letters submitted by various

officials of the same mortgage corporation; they were counted as one

comment. Two other comments were substantially similar letters

submitted by different offices of the same bank and mortgage lending

subsidiary; they also were counted as one comment, but minor

variations between the two were considered.

Twenty-one comments were duplicate comments submitted by various

originators and servicers, including the United States Department of

Agriculture. One bank and trust submitted nearly identical comments

as the Mortgage Bankers of America (MBA), while the Oregon Bankers

Association submitted nearly identical comments as the American

Bankers Association (ABA). The Mortgage Bankers Association of

Minnesota adopted with one small addition the comments of Norwest.

Since these comments were submitted by separate entities, they are

all counted as separate comments.

One commenter simply summarized the proposed rule without taking

a position on any of the proposals.

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One-hundred two of the comments came from originators/

servicers.11 Fourteen comments came from trade associations.

Four came from individual consumers, three from tax service providers,

two from members of Congress, four from financial software companies,

one from a state lending agency, one from a mortgage insurer, one from

a builder, and two from persons whose professional interest in the rule

could not be determined.

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\11\ In some cases, the precise nature of the business was not

clear from the comment. Moreover, it did not appear that the

comments differed markedly depending on the precise nature of the

business. For example, it did not appear that the comments from

retail lenders differed markedly from those from mortgage brokers,

or that the comments from one type of retail lender differed from

those or other types of retail lenders. Thus, all businesses that

originate, service, and/or broker loans are designated as

``originators/servicers'' in this preamble.

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B. What Commenters Commented On

The Annual vs. Installment Disbursements problem attracted the most

comments. One-hundred twenty-eight commenters, including all but one of

the trade associations and all but two of the originators/servicers,

commented on this issue. The Payment Shock Problem received the second

highest number of comments, with one-hundred

[[Page 3221]]

sixteen commenters, including ninety-six originators/servicers and all

but two of the trade associations. The Single-Item Analysis With

Aggregate Adjustment problem also attracted a significant number of

comments, seventy-eight in all, including sixty-five originators/

servicers and ten trade associations. Only seventeen commenters, twelve

originators/servicers and five trade associations, commented on the

additional proposed change concerning lead-based paint.

C. Overview of Positions

The overwhelming majority of originators, servicers and mortgage

brokers opposed those options for the first two issues that were

designed to provide borrowers more choices, citing the costs and

burdens of such an approach. Three commenters, including Norwest,

criticized those options as being inconsistent with the principles the

Department had articulated, asserting that the Consumer Choice options

would increase the cost of homeownership. In contrast, the few

consumers and members of Congress who commented on the first issue

supported Consumer Choice approaches; these commenters did not comment

on the Payment Shock problem.

On the Single-Item Analysis With Aggregate Adjustment problem, more

commenters supported the proposed change than opposed it. Opinion was

nearly evenly divided on the additional proposed change concerning

lead-based paint.

Nine commenters, including the American Bankers Association (ABA),

commented that no changes should be made at this time and instead, the

Department should wait several years before considering further changes

to Regulation X, at least until the changes made under the 1994-1995

escrow rules are fully implemented. (Those provisions took effect May

24, 1995 but provided for a three-year phase in for existing escrow

accounts which expires October 27, 1997.)

The reasons given by the ABA, which were echoed by the Oregon

Bankers Association, for not making any changes to the rule were that

the rule would alter the escrow accounting systems at the very time the

Department's new rules are bring fully implemented, causing major

problems and an excessive burden for banks and other mortgage

servicers. The New York Credit Union League agreed, emphasizing the

costly changes that are already being made as a result of that earlier

rule.

A bank holding company, in terms echoed by other originators and

servicers, commented that there was no need to change the rules now as

those borrowers with existing accounts have already benefited from or

suffered the consequences of the 1994-1995 escrow rules and have

subsequently adjusted to the changes and many of the problems created

by that rule are over. Thus, it would be premature to make further

changes, and doing so may only again create the same sort of initial

problems that were created by the 1994-1995 escrow rules. GE Capital

recommended waiting at least two years before revisiting the need for

any changes. Another servicer and originator recommended waiting 24 to

36 months before making further changes. A bank compliance officer and

a bank holding company also recommended against changes being made at

this time.

Several other commenters recommended that the Department hold off

action on specific portions of the rule. Those comments are analyzed

separately under the portion of the preamble discussing that aspect of

the rule.

In contrast, many commenters emphasized the importance of making

changes to address their particular issues of concern, particularly the

Payment Shock problem. These comments are summarized under the

particular issues discussed later in this summary.

V. Annual vs. Installment Disbursements Problem--Comments Received,

Approach Adopted in Today's Final Rule, Basis for Approach Adopted,

Basis for Rejecting Alternative Approaches, Clarifications

A. Comments Received

Through the comments received on the proposed rule, the Department

gained a better understanding of the Annual vs. Installment

Disbursements problem. The Department learned more about how servicers

have been addressing the problem of setting the appropriate

disbursement date when given a choice of annual or installment

disbursements. The comments received indicated that practices have not

been uniform and that in some cases, originators/servicers have been

using creative approaches to meeting consumer's needs. Five

originators/servicers and two tax services indicated that they were

disbursing in installments unless a discount was offered for annual

disbursements that the servicer thought was a large enough discount to

be in the borrower's interest, in which case the disbursements were

made annually; one trade association indicated this was the approach of

most of its members as well. One savings and loan indicated that its

practice was to accommodate individual borrowers by switching people

who complain to whichever method they prefer.

Other originators/servicers are using practices that do not provide

as much flexibility for the consumer. In many cases, the originators/

servicers indicated that they believed such practices were compelled by

the existing RESPA regulations. For example, thirteen originators/

servicers indicated that when such a choice is offered, they currently

disburse in installments unless a discount is offered for annual

disbursements, in which case they always disburse annually regardless

of how insignificant the discount may be. Two originators/servicers and

one tax service indicated that if no discount is offered for annual

disbursements but a service fee is charged for installment

disbursements, they disburse annually, no matter how insignificant the

service fee may be.

A few commenters noted that in many jurisdictions, the installment

option is only available for individuals, not servicers. Other

commenters noted special rules that apply in particular States, such as

Wisconsin, where the practice is to pay taxes in the year levied, even

though they do not have to be paid until the following year, and

Maryland, where a law provides that first time homebuyers may choose

between annual and installment disbursements with a consumer disclosure

highlighting differences between the two methods.

The Department also learned more about the discounts obtained by

servicers for borrowers, e.g., how large the discounts are and when

disbursements must be made in order to receive the discounts.

Commenters estimated the size of the discounts to range from around 1-5

percent of the property tax bill, with only two commenters indicating

that discounts ranged up to 10 percent, and only one commenter

indicating they tended to be less than one percent. Several

commenters--three consumers, two members of Congress, two originators/

servicers, one trade association--expressed the view that discounts are

small and not in the borrower's interest to disburse in order to

collect them. Two originators/servicers expressed the opposite view

that discounts tended to be large and in the borrower's interest to

obtain. The Department notes that, under reasonable

assumptions,12 a

[[Page 3222]]

discount of 1 percent of the annual tax bill converts to approximately

a 4 percent annualized return; a 5 percent discount converts to

approximately a 23 percent annualized return.

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\12\ The assumptions are that if, for example, the entire tax

bill is paid on January 1, the discount applies to the entire bill.

Otherwise, half of the bill is due on January 1 and half is due on

July 1.

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Several commenters commented on the extent of the problem. Two

consumers from New York asserted that borrowers whose servicers

switched from installments to annual disbursements were adversely

impacted. One, a senior citizen, explained that she and her husband

were required by their servicer either to make a lump sum payment of

almost $1,500 with a monthly increase of over $150 or no lump sum

payment but a monthly increase of over $200, to obtain a discount of

only 1 percent. Another reported that his mortgage payment was

increased over $100 for a mere $8 discount for annual tax payments.

Other commenters, however, challenged the Department's perspective

that the issue of Annual vs. Installment Disbursements was a problem in

need of fixing. Some questioned the Department's evidence that there

was a problem. One bank expressed doubt about how many borrowers were

actually affected, and to what extent, by the 1994-1995 escrow rules,

indicating that the impact of the rule change had already been

absorbed. Four originators/servicers, including Citicorp and First

American Real Estate Tax Service, Inc., a large tax service,

specifically asserted that there was no current problem. Citicorp

asserted that there were few problems with the existing rule for

borrowers or industry and that it was premature to change the 1994-1995

escrow rules until there was more experience operating under it.

Citicorp recommended waiting until 1998 to make further changes. Ten

commenters in the origination and servicing industry, including

NationsBank and GE Capital, as well as the Mortgage Bankers Association

(MBA), also asserted that the impact of the 1994-1995 escrow rules had

already been absorbed, and any impacts on consumers with existing loans

had already taken place.

Most of the commenters commented on one or more of the specific

alternative proposals for addressing the problem.13 The

overwhelming majority of originators, servicers, and mortgage brokers

opposed Consumer Choice; there was some division of opinion on what

alternative approach to take. A modified version of the ``Keep But

Clarify Current Requirements'' alternative garnered the most consistent

support; the modification was that the restriction on servicers

switching disbursement methods when servicing is transferred be

eliminated. Opinion was fairly evenly divided on the merits of the

``Servicer Flexibility'' alternative.

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\13\ In contrast, one commenter, a Wisconsin bank holding

company, seemed to question the Department's legal authority to

propose any solution to the problem. The commenter asserted that the

Department can prohibit over-escrowing and pre-accrual or other

servicer practices ``that require borrowers to have more than the

amount of the projected property tax plus the permissible cushion in

the escrow account before the tax lien attaches, but it was not the

purpose of Congress that RESPA limit a lender's right to keep

mortgaged property free of liens, and the authority of the

Department to interpret RESPA so as to do so is questionable.'' The

commenter criticized any proposal that would establish detailed

rules regarding when servicer may disburse funds to pay property

taxes after the tax lien has attached to the property.

This objection seems to raise an issue that was settled in the

May 1995 rule, which elevated cash flow over lien priority. The

Department has clear legal authority to address the matter of

disbursements, as part of the Secretary's rulemaking authority

pursuant to section 19(a) of RESPA (12 U.S.C. 2617) to interpret

RESPA, including section 10 and section 6(g). Section 10(a) requires

that disbursements be made in accordance with prudent lending

practice. Section 10(a)(2) prohibits lenders from requiring

consumers to deposit in escrow accounts more than one-twelfth of the

total amount of the estimated taxes, insurance premiums and other

charges which are ``reasonably anticipated'' to be paid on dates

during the ensuing twelve months plus a cushion. Section 6(g)

requires that disbursements be made as payments become due. By

promulgating a rule to address the Annual vs. Installments

Disbursement problem, the Department would be acting appropriately

under one or more of these statutory provisions.

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1. Comments on Consumer Choice Alternative

Only seven commenters supported Consumer Choice. The California

Association of Realtors (CAR) specifically supported applying the

Consumer Choice option to new loans as well as existing loans. CAR

commented that the benefits would outweigh the marginal costs and that

it favored approaches that provide consumers with as much information

as possible and the opportunity, when fully informed, to make choices

about the servicing of their loans and the related impound/escrow

accounting. The CAR added that if the consumer failed to make a choice,

disbursements should be made on an installment basis.

Two comments from elected officials, one from Representative Peter

King of New York and one joint letter from Senator Alphonse D'Amato,

Representative King, and Representative Dan Frisa also endorsed the

Consumer Choice approach, focusing on its application to existing

loans. Both letters expressed deep concern for homeowners who were

negatively impacted when servicers switched disbursement methods and

urged the Department to allow homeowners to have the choice to return

to their prior disbursement method. Representative King's letter stated

that consumers, not financial institutions, will be able to determine

which method of tax payment is best for them and that allowing such a

choice would further the goals of RESPA. Senator D'Amato's letter

stated that ideally homeowners should be given the option to return to

their previous disbursement methods with the excess of any escrow

accounts returned and, at a minimum, their servicers must inquire as to

the homeowners' preference.

Four homeowners in New York advocated allowing homeowners to have

the right to decide whether they wish to forego a discount for annual

disbursements and instead have their taxes disbursed in installments.

All focused on the benefits of applying Consumer Choice to existing

loans, complaining that they were left with a shortage in their account

and suffered severe financial hardship trying to make up the shortage

when their servicers switched disbursement methods.

In addition, one federal credit union's comments gave tepid support

to the Consumer Choice option if it were limited to new loans. The

credit union indicated that offering the choice to new loans would only

entail the burden of preparing and explaining the form. It indicated,

however, that for existing loans Consumer Choice would be costly in

terms of staff, time, and the mailing of the selection format, and

would be confusing to borrowers. The credit union also indicated that

since borrowers could refinance anyway, there was no apparent need to

offer existing borrowers a choice.

In contrast, 107 commenters opposed the adoption of Consumer Choice

(91 originators/servicers, 11 trade associations, 3 tax services, 2

financial software companies, and 1 person whose professional interest

was not known). Only one commenter, a credit union, appeared to limit

its opposition to the Consumer Choice alternative to its application to

existing loans. All of the other commenters appeared to oppose the

application of Consumer Choice regardless of whether it extended to

both new and existing loans, or only to new loans.

Most commenters did not separate out their objections to Consumer

Choice as it would apply to new loans as opposed to existing loans.

Whether the commenters separated out their objections or not did not

affect the objections raised. Accordingly, all objections are discussed

together below,

[[Page 3223]]

with an indication, as applicable, if an objection was raised

specifically in one context as opposed to another.

The most common objections made by commenters were:

1. It would cause miscellaneous or general increases in costs and/

or administrative burdens, such as costs and burdens relating to

originating or servicing (64 commenters--60 originators/servicers, 3

trade associations, 1 tax service).

2. They were concerned about the specific costs and burdens of

consumer disclosure, including producing and mailing disclosures,

soliciting preferences, processing disclosures, tracking selection, and

maintaining information on selection (50 commenters--45 originators/

servicers, 4 trade associations, 1 financial software company) or

opposed the addition of a new disclosure in general (8 commenters--6

originators/servicers, 1 financial software company, 1 person of

unknown professional interest).

3. It would require more customer service to explain choices and

answer questions for consumers, which would raise costs, workload, and

require more staff (46 commenters--41 originators/servicers, 4 trade

associations, 1 financial software company).

4. The cost would be passed on to consumers (44 commenters--35

originators/servicers, 6 trade associations, 2 tax services, 1

financial software company).

5. They did not want to make the system and programming changes,

acquire the new software, or incur the expense of additional

programming that would be needed (38 commenters--32 originators/

servicers, 3 trade associations, 2 financial software companies, 1 tax

service).

6. It would cause consumer confusion and consumers would not be

able to make an educated choice (30 commenters--25 originators/

servicers, 3 trade associations, 1 financial software company, 1 person

of unknown professional interest).

7. They did not want to have to maintain two, or possibly many

more, different disbursement systems for every taxing jurisdiction

where they service loans (24 commenters--18 originators/servicers, 5

trade associations, 1 tax service).

8. It would lead to more errors and could result in missed payments

and interest and penalties (24 commenters--21 originators/servicers, 1

trade association, 1 tax service, 1 financial software company).

9. It would create hardship for taxing authorities (18 commenters),

such as increased administrative costs/burden and workload due to lack

of uniformity and similar factors (12 originators/servicers),

unexpected shortfalls in tax receipts (8 commenters--7 originators/

servicers, 1 trade association), and unspecified or miscellaneous

difficulties (2 originators/servicers).

10. It would require additional training of staff (8 commenters--7

originators/servicers, 1 trade association) or require additional staff

and/or staff time for processing (13 commenters--12 originators/

servicers, 1 trade association).

11. It would result in impossibilities and impracticalities (15

commenters) including that computer and other systems could not handle

Consumer Choice (6 commenters--5 originators/servicers, 1 trade

association).

12. It would increase the need for manual processing or interfere

with technological advances (12 commenters--10 originators/servicers, 1

tax service, 1 financial software company).

13. It would be less efficient (11 commenters--10 originators/

servicers, 1 trade association).

14. It would result in a loss of uniformity (10 commenters--9

originators/servicers, 1 trade association).

In addition, several commenters indicated that several aspects of

the Consumer Choice alternative in the proposed rule were unclear and

required further clarification. For example, eight originators/

servicers and a trade association indicated that the proposed rule was

not sufficiently clear about what would happen if the customer did not

return the format or how a servicer should document that a borrower

made no selection. Several commenters recommended that if the

Department were to proceed with Consumer Choice, it should make

variations of one type or another from the way in which it was

proposed.

In its proposed rule, the Department asked Question 4, which was

designed to learn more about the potential impact on servicers of

requiring them to provide borrowers with a one-time choice at closing

as opposed to allowing borrowers to switch disbursement methods during

the life of the loan. The answers received to this question

substantially overlapped with the comments discussed above regarding

the benefits and disadvantages of Consumer Choice.

Twenty-eight commenters (24 originators/servicers, 3 trade

associations, 1 tax service) explicitly indicated in their responses to

this question that not even a one-time choice should be provided to

consumers, but that if the Department chose the Consumer Choice

alternative anyway, it should be limited to a one-time choice. This

view was implicit in the comments of several others. Among the

drawbacks cited for providing more than a one-time choice were the

following:

1. It would increase the burden if servicers needed to make

constant changes (nine commenters--eight originators/servicers, one

trade association).

2. It would result in higher costs (eight commenters--seven

originators/servicers, one tax service).

3. It would lead to more errors, confusion, uncertainty and/or

noncompliance (seven commenters--five originators/servicers, one trade

association).

4. It would be impossible, impractical, or unfair (five

originators/servicers).

In its proposed rule, the Department also asked three related

questions (Questions 2, 5, and 11) that were designed to elicit

responses as to whether, in general, the approach in the final rule

should make a distinction between loans that settle before the

effective date of a final rule and loans that settle on or after the

effective date. While the Department posed the questions so as to be

applicable regardless of which alternative was selected, virtually all

who answered the questions did so in the context of applying Consumer

Choice. The answers received to these questions substantially

overlapped each other, as well as overlapping with the comments

received on Consumer Choice, and thus are discussed together here.

Fourteen commenters--twelve originators/servicers and two trade

associations--emphasized the drawbacks to applying new rules to

existing loans, as opposed to only applying it to new loans. The

drawbacks to applying consumer choice to all loans included: (1) it

would be more costly/burdensome to apply to all (eight commenters); (2)

it may result in shortages (two commenters); and (3) it would cause

more confusion, disruption, and/or chance for error (two commenters).

In contrast, 13 commenters--11 originators/servicers, 1 trade

association, and 1 financial software company--emphasized the drawbacks

to trying to apply new rules only to new loans, thereby requiring

maintaining separate rules for a portion of their portfolio. These

commenters either supported or leaned toward uniform treatment of all

loans, some with mixed feelings about the significant burdens it would

impose to apply a change to existing loans. The drawbacks cited

[[Page 3224]]

included: (1) the need for uniformity and consistency (five

commenters); (2) it would be costly and burdensome to distinguish (four

commenters); (3) it would result in more borrower confusion or

dissatisfaction (three commenters); (4) taxing authorities could not

gauge the number and amount of tax payments (two commenters); and (5)

more errors would result.

Finally, in the proposed rule the Department asked Question 10,

which was designed to elicit comments on whether the Department should

apply a Consumer Choice approach to other escrow items for which a

choice between installments and annual disbursements may be offered. No

commenter gave a clear answer that supported applying a consumer's

choice to other escrow items. In contrast, 27 commenters (23

originators/servicers and 3 trade associations) opposed extending a

consumer's choice to other escrow items. The reasons given for opposing

such an approach included the following:

1. Additional costs and burdens would result (e.g., insurance

companies impose a service charge for installment payments and this

would be passed on to consumer) (19 commenters--17 originators/

servicers, 2 trade associations).

2. There would be no benefit to consumers (e.g., taxes are the

largest item so the savings from installments will be negligible) (10

commenters--9 originators/servicers and 1 trade association).

3. More errors, customer dissatisfaction, and customer confusion

would result (six commenters--five originators/servicers and one trade

association).

2. Comments on Servicer Flexibility Alternative

Twenty-five commenters--18 originators/servicers, 5 trade

associations, 1 tax service, and 1 financial software company--

supported Servicer Flexibility. Eight of these commenters (seven

originators/servicers and one financial software company) who otherwise

supported Servicer Flexibility, however, did not support the aspect of

Servicer Flexibility that would have included restrictions on changing

disbursement methods when servicing rights were transferred. Indeed,

two of these originators/servicers made a special point of indicating

that they would not support Servicer Flexibility if it included that

element.

The most common reasons for supporting Servicer Flexibility

included:

1. It would be flexible (six commenters--three originators/

servicers, three trade associations).

2. It would be easy to administer and cause little disruption (five

commenters--two originators/servicers, two trade associations, one

financial software company).

3. It would not be costly (four originators/servicers).

4. The lender/servicer is likely to do what is in the consumer's

interest anyway; Servicer Flexibility would allow servicers to

accommodate borrowers (four commenters--two originators/servicers, two

trade associations).

In contrast, 19 commenters--14 originators/servicers, 4 trade

associations, and 1 tax service--opposed Servicer Flexibility. The

reasons for opposing Servicer Flexibility included:

1. It would not create a system that is uniform, standardized,

consistent, or certain; there would still be no clarity (12

commenters--9 originators/servicers, 2 trade associations, 1 tax

service).

2. The restriction on changing disbursement methods when there is a

transfer of servicing or reasons related thereto was objectionable

(five commenters--three originators/servicers, one trade association,

one tax service).

3. Increased costs would result (five commenters--four originators/

servicers, one trade association).

4. It might not result in the best method for consumers (two

originators/servicers, one trade association) and litigation would

result (two originators/servicers).

In addition, one federal credit union suggested that the Department

adopt a variation on Servicer Flexibility under which the servicer

should notify the borrower when the disbursement method is being

changed, changing should be limited to when it benefits the borrower

(such as taking advantage of a sufficient discount), and the annual

statement could be used to inform the borrower of the method used.

3. Comments on Keep, But Clarify, Current Requirements Alternative

Sixty-five commenters--58 originators/servicers, 4 trade

associations, 1 tax service, 1 financial software company, and 1 State

lending agency--supported the Keep, But Clarify, Current Requirements

alternative. Six other commenters (two originators/servicers, three

trade associations, and one tax service) indicated it was their second

choice. Forty-eight of the commenters who otherwise supported Keep, But

Clarify, Current Requirements as either their first or second choice

(46 originators/servicers, 1 trade association, and 1 State lending

agency), did not support the aspect of this alternative that would

include restrictions on changing disbursement methods when servicing

rights were transferred. Indeed, 30 of these commenters specifically

emphasized their objection to this aspect of this alternative in

discussing the support they otherwise would give to it.

The reasons given by those who supported Keep, But Clarify, Current

Requirements as their first choice were substantially the same as the

reasons given by the three originators/servicers who indicated it was

their second choice. The most common reasons of both groups of

commenters included:

1. It would be good for consumers for miscellaneous or unspecified

reasons (26 commenters--24 originators/servicers, 1 State lending

agency, 1 financial software company) or because it would be flexible

and allow accommodating customers (8 commenters--5 originators/

servicers, 3 trade associations).

2. It would cause little disruption, would not be burdensome, would

not require much change, and would be efficient (11 commenters--8

originators/servicers, 2 trade associations, 1 State lending agency).

3. It would not be costly and any costs associated with it would be

within an acceptable range (eight commenters--six originators/

servicers, two trade associations).

4. It would be a balanced, sensible, practical compromise (six

commenters--five originators/servicers, one trade association)

5. It was favored but no specific reason was given (20 commenters--

17 originators/servicers, 2 trade associations, 1 tax service).

In contrast, eight originators/servicers and two trade associations

opposed Keep, But Clarify, Current Requirements. The most common

reasons given for opposing it included the following:

1. It would not standardize the industry (two originators/

servicers).

2. It would be unclear, vague, and not specific (two originators/

servicers).

3. It would be bad for consumers (e.g., consumer dissatisfaction,

confusion, disruption, loss of tax deduction) (two originators/

servicers, one trade association).

4. It would be objectionable because of the restriction on

switching disbursement methods when there is a transfer of servicing

(two commenters--

[[Page 3225]]

one originator/servicer, one trade association).

Several commenters recommended variations on Keep, But Clarify,

Current Requirements such as requiring installments unless there is a

discount for annual disbursements, in which case making annual

disbursements mandatory to get the discount instead of optional for

servicer. Other commenters encouraged the Department to consider other

approaches, such as making no changes at all to address this problem.

4. Comments on Proposed Rule Provision Prohibiting Switching

Disbursement Methods Without Borrower's Consent

Only seven commenters supported, in any context, prohibiting a

servicer or transferor servicer from changing the disbursement method,

as long as a choice exists, without the borrower's prior written

consent. Two appeared to support it as a general proposition regardless

of the alternative selected. One was Senator D'Amato, who asserted that

changes without the borrower's approval ``have been the primary culprit

in the unfair treatment which mortgage lenders have imposed on the

homeowners of Long Island, chiefly by requiring hundreds of dollars per

month from homeowners in escrow payments in order to take advantage of

minuscule discounts through the payment of local taxes on an annual

basis.'' The other was a federal savings bank, which gave no specific

reasons other than suggesting it would be less complicated to do so.

One servicer indicated that if Servicer Flexibility were adopted,

it would be logical to prohibit subsequent servicers from changing the

disbursement method without the borrower's written consent. This

commenter stated that it understands the need to get the borrower's

consent before changing the method of tax disbursements when servicing

is transferred.

Were the Department to adopt the alternative of Keep, But Clarify,

Current Requirements, three commenters supported the restriction.

America's Community Bankers (ACB) supported the restriction, so long as

the disbursement method continues to be offered by the taxing

authority. A large bank with a mortgage lending subsidiary endorsed

allowing servicers and subsequent servicers to change the disbursement

method only to bring the escrow account into compliance with RESPA

under a revised interpretation by the Department. One other servicer

commented that requiring the same disbursement date when servicing is

transferred is beneficial in that it protects against payment shock for

borrowers.

In contrast, 71 commenters opposed the restriction. Fifty-seven of

those who opposed it (including 21 originators/servicers submitting the

same form letter) discussed their opposition as a general objection

applicable to whichever of the three alternatives for addressing the

Annual vs. Installment Disbursements problem might be adopted. These 57

included 51 originators/servicers, 4 trade associations, a State

lending agency, and a financial software company. Fourteen expressed

their opposition in connection with one or more of the specific

alternative solutions proposed, but none of these commenters either

stated or suggested that the proposal would be acceptable in the

context of a different alternative being adopted. Since the objections

were consistent regardless of whether expressed in connection with one

or all alternatives, all the comments on this issue are discussed in

this section. One servicer specifically said that it opposed all the

alternatives presented in the proposed rule because of this common

feature.

The arguments against including the restriction in the final rule

primarily focused on the way in which such a restriction would impair

the value of servicing rights and the costs and administrative burdens

associated with the restriction. Many of the arguments against the

restriction overlapped each other. The most common reasons given

included that:

1. It would result in a variety of miscellaneous administrative

burdens (35 commenters--34 originators/servicers and 1 trade

association).

2. It would increase costs for servicers, such as system and

processing changes including computer system changes and the burden on

the due diligence process (14 commenters--12 originators/servicers and

2 trade associations) and would increase costs to consumers (6

commenters--4 originators/servicers and 2 trade associations).

3. The restriction would impair the value of servicing rights (13

commenters--10 originators/servicers, 2 trade associations, 1 State

lending agency), such as by creating inefficiency and increased cost (3

originators/servicers, 1 trade association).

4. As the restriction applies to the Keep, But Clarify, Current

Requirements alternative, it would be a new requirement, rather than a

clarification of an existing requirement (seven commenters--six

originators/servicers and one trade association).

5. It would result in a variety of practical difficulties or

impossibilities (six commenters--five originators/servicers and one

trade association).

6. It would reduce the number of sales and transfers of servicing

rights (five commenters--four originators/servicers and one trade

association).

7. No problem exists that needs to be fixed by such a restriction

(five originators/servicers).

In addition, three commenters (two originators/servicers, one trade

association) indicated their belief that the Department would lack

legal authority to mandate such a restriction. Three originators/

servicers requested that the Department clarify certain points

pertaining to this restriction.

Six commenters proposed variations on the restriction. Three

commenters supported limiting the ability of the acquiring servicer to

change the disbursement method to particular types of situations. One

federal credit union indicated that it supported restricting a servicer

acquiring servicing rights from changing disbursement methods unless

the change would benefit the borrower, but gave no details on how to

apply such a standard. The Georgia Housing and Finance Administration

favored limiting servicers from making changes to the disbursements

method to situations involving transfers of servicing, borrower

hardships, taxing authority changes, system conversion, and other major

organizational changes. GE Capital asked the Department to allow a

change in disbursement dates or methods after a transfer of servicing

if the dates are incorrect or the methodology is not available to the

new servicer. Three mortgage companies suggested that servicers should

simply include in the letter notifying the consumer of a transfer of

servicing what disbursement method will be used, prior to making the

change.

B. Approach Adopted in Today's Final Rule

Having carefully analyzed the comments received, the Department has

decided to adopt, with modifications, the Keep, But Clarify, Current

Requirements alternative. The Department is revising the rule to

provide that servicers must make timely payments, that is, on or before

the deadline to avoid a penalty, and advance funds as necessary, so

long as the borrower's payment is not more than 30 days overdue. The

rule also provides special requirements for property taxes when the

taxing jurisdiction offers the servicer a choice between annual

disbursements with a discount and installment disbursements. In such

[[Page 3226]]

cases, if the taxing jurisdiction neither offers a discount for

disbursements on a lump sum annual basis nor imposes any additional

charge or fee for installment disbursements, the servicer must make

disbursements on an installment basis, unless the servicer and borrower

agree otherwise. If, however, the taxing jurisdiction offers a discount

for disbursements on a lump sum annual basis or imposes any additional

charge or fee for installment disbursements, the servicer may, at the

servicer's discretion (but is not required by RESPA to), make lump sum

annual disbursements, as long as such method of disbursement complies

with the requirements of Sec. 3500.17 (k)(1) and (k)(2) of this rule.

HUD encourages, but does not require, the servicer to follow the

preference of the borrower, if such preference is known to the

servicer.

This final rule also incorporates into the regulations a provision

that the servicer and borrower may mutually agree, on an individual

case basis, to a different disbursement basis (installment or annual)

or disbursement dates, than the rule would otherwise require. This

provision is consistent with, but more expansive than, the statement

contained in the discussion in the preamble to the Department's May 9,

1995 rule (60 FR 24734), which indicated that such agreements were

allowed after settlement only. At the time the preamble to the May 1995

rule was written, the Department felt that the concern for borrower

coercion was so great as to make it necessary to limit agreements

concerning disbursement dates to the period after settlement, when the

likelihood of coercion was reduced. The Department understands,

however, that allowing such agreements only after settlement

discourages them, since it is more burdensome to change the

disbursement basis or date after settlement than to set up the account

from the start in a way that is mutually agreeable to the borrower and

servicer.

This final rule emphasizes that these agreements must be completely

voluntary and that neither loan approval nor any term of the loan may

be conditioned on the borrower's agreeing to a different disbursement

basis or disbursement date for property taxes. The rule does, however,

allow such agreements to be made prior to settlement, thereby avoiding

the need to make postsettlement changes in the disbursement basis or

dates when such an agreement is reached before settlement. This rule

also clarifies that whatever the borrower and servicer agree to must

avoid a penalty, comply with normal lending practice of the lender and

local custom, and constitute prudent lending practice. This new

provision provides flexibility. It allows the parties to agree, for

example, to annual disbursements of property taxes even if there is no

discount where an installment option is offered.

This final rule departs from Keep, But Clarify, Current

Requirements as articulated in the proposed rule in that, under this

final rule, the only specific requirements for choosing between annual

and installment disbursements pertain to property taxes, not other

escrow items. The reason the Department distinguishes property taxes

from other escrow items is that the concerns that have been raised to

the Department on the Annual vs. Installment Disbursement issue have

been limited to property taxes. For most consumers, property taxes are

much larger than hazard insurance and other escrow items.

This final rule also departs from Keep, But Clarify, Current

Requirements as articulated in the proposed rule in that, for the

reasons discussed in Part V(D)(3) of this preamble below, it does not

adopt the restriction in the proposed rule that a servicer and

subsequent servicers would be prohibited from changing the method of

disbursement without the borrower's prior written consent, as long as a

choice continues to exist in the taxing jurisdiction.

Finally, the final rule adds a definition of ``penalty'' to the

definitions in Sec. 3500.17. This definition clarifies that a penalty

means a late charge imposed for paying after the disbursement is due.

It does not include any additional charge or fee associated with

choosing installment disbursements as opposed to annual disbursements

or for choosing one installment plan over another. In comments on the

proposed rule, four originators/servicers and one tax service commented

that the proposed rule had been unclear whether a service fee levied on

installment disbursements is regarded as a penalty. These commenters

took the position that the servicers may or must use annual

disbursements to avoid a penalty (service charge, interest payment, or

other fee) for paying in installments, not just to take advantage of a

discount available for annual disbursements. One of these commenters

questioned whether the existence of a service charge for installment

disbursements makes an annual disbursement plan without such a service

charge the equivalent of a discount.

Notwithstanding these comments, the Department believes the better

approach is not to regard a service charge, interest payment, or other

fee associated with choosing installment disbursements as opposed to

annual disbursements as a penalty to be avoided. Rather, if a service

charge, interest payment, or other fee is imposed for choosing

installment disbursements as opposed to annual disbursements, the

ability to avoid them by paying annually creates, in essence, a

discount for annual disbursements. With respect to disbursements for

property taxes, once the choice is viewed as between annual

disbursements at a discount and installment disbursements, in

accordance with this rule, the servicer may, but is not required by

RESPA to,14 pay annually. Thus, for property taxes, the

servicer may choose to disburse the property taxes in installments and

incur the service charge, interest payment, or other fee associated

with choosing installment disbursements, or may avoid them by

disbursing annually. The servicer is encouraged, but not required, to

follow the preference of the borrower.15

---------------------------------------------------------------------------

\14\ The caveat, ``by RESPA,'' is designed to allow for the

possibility that State law could require annual disbursements.

\15\ For other escrow items, the servicer may disburse annually

or in installments, so long as the method avoids a penalty and the

disbursement basis and disbursement date complies with the normal

lending practice of the lender and local custom, and constitutes

prudent lending practice.

---------------------------------------------------------------------------

Stated in other terms, for property taxes, the servicer should add

up the total payments associated with disbursing annually and compare

that amount to the total payments associated with disbursing in

installments. In making those calculations, the servicer should take

into account any applicable discounts or service charges. If the total

amount associated with disbursing property taxes annually is greater

than or equal to the total amount associated with disbursing in

installments, the servicer must disburse the property taxes in

installments, except when the servicer and borrower mutually agree

otherwise. If, however, the total amount for disbursing the property

taxes in installments is greater than the total amount for disbursing

them annually, the servicer may, but is not required by RESPA to,

disburse them annually. The servicer is encouraged, but not required,

to follow the preference of the borrower.

C. Basis for Approach Adopted

The preamble to the proposed rule indicated that the Department

believed the advantage of Keep, But Clarify, Current Requirements would

be that, like Servicer Flexibility, it would provide flexibility to

servicers. It would also allow servicers to accommodate borrowers with

a particular preference.

[[Page 3227]]

To the extent that the Department thought Keep, But Clarify, Current

Requirements had a potential drawback, it was that it would not

guarantee that servicers would accommodate the preferences of

individual borrowers, providing less choice for borrowers.

The comments received served to confirm the Department's belief

that Keep, But Clarify, Current Requirements, with some modifications,

is a workable solution to this problem. Commenters noted many positive

reasons for choosing this alternative. The Department is persuaded

that, on balance, it is the best approach for meeting consumers' needs

and balancing those against the valid concerns of the industry. Such an

approach will cause the least disruption and burden and will be the

least costly approach, yet it is sufficiently flexible to accommodate

the preferences of individual consumers.

By clarifying the regulations in a way that allows more flexibility

for servicers and consumers, the Department intends to encourage more

servicers to adopt the types of best practices that some servicers are

already using that ensure flexibility for consumers. These best

practices to address the Annual vs. Installment Disbursements problem

include:

Disbursing property taxes in installments unless a

discount is offered for annual disbursements that the servicer, based

on its best business judgment, believes is a large enough discount to

be in the borrower's interest, in which case the servicer makes

disbursements annually.

Accommodating individual borrowers by switching borrowers

who complain to whichever method they prefer for the disbursement of

property taxes.

These two practices are examples of the types of best practices

that some originators/servicers in the industry are using today, even

without a Government requirement. The Department would encourage

servicers to adopt these practices so that they will become more

widespread.

In contrast, the Department intends to discourage practices that do

not provide as much flexibility for the consumer. These include:

If a choice between annual disbursements with a discount

or installment disbursements is offered, always disbursing annually

regardless of how insignificant the discount may be and despite the

consumer's stated preference for installment disbursements.

If a choice between annual disbursements or installment

disbursements with an additional charge or fee for installment

disbursements is offered, always disbursing annually regardless of how

insignificant the charge or fee for installment disbursements may be

and despite the consumer's stated preference for installment

disbursements.

The Department intends that the revisions made in this final rule

clarify that these two inflexible practices were not, and are not,

compelled by the Department; the Department does not in any way mandate

such practices. The Department encourages servicers to use practices

that are more consumer friendly.

D. Basis for Rejecting Alternative Approaches

1. Rejection of Consumer Choice Alternative

The preamble to the proposed rule indicated that this approach

would provide the greatest flexibility to the borrower. However, the

Department also noted that it could impose higher costs on servicers.

The Department observed that servicers would likely need two different

disbursement systems to reflect the disbursement preferences of

borrowers.

While the Department believes that it would have legal authority to

impose Consumer Choice as part of the Secretary's rulemaking authority,

it has decided not to do so. The Department is persuaded that the types

of costs and burdens associated with such an approach are unwarranted

at this time. The cost of implementing Consumer Choice with respect to

disbursing property taxes on an installment or annual basis would be

substantial according to most of the comments received on this issue.

New software and operating procedures would have to be developed for

originators and all those involved in servicing. Some efficiencies

would be lost as multiple processes were employed for making

disbursements to taxing authorities, when only one process had been

followed before.

Additionally, the Department gathered information from members of

the servicing industry on the cost of the Consumer Choice alternative.

The Department believes that the cost per account subject to Consumer

Choice would be significant, even under a very simple system subject to

the following assumptions: (1) a choice would only be permitted at

origination with no provisions for the consumer to opt to change the

disbursement method later and (2) little in terms of disclosure to the

consumer would be provided other than notifying the consumer that a

one-time choice at origination was permitted. To the extent that the

disclosure required more information or the consumer could opt to

change the disbursement method during the life of the loan, the costs

would be greater.

The additional costs of consumer choice could be justified if there

were commensurate benefits to consumers. But the vast majority of

consumer complaints concerning the disbursement method arose out of the

transition associated with the 1994-1995 escrow rules. These were one-

time, as opposed to ongoing, problems. Complaints about this problem

have recently become rare.

Given that the transition associated with the 1994-1995 escrow

rules is almost complete and that this transition has been the source

of essentially all the complaints concerning the Annual vs. Installment

Disbursements problem, the Department believes that only a small

percentage of consumers would benefit from the Consumer Choice

alternative. It is not anticipated that the benefits to the few who

would choose a basis other than what the servicer would choose under

the rule would exceed the costs associated with that option. Since it

is consumers who would probably bear the additional costs of providing

choice, the Department does not believe it is in the consumers' overall

best interest to require consumer choice.

The Department was also influenced by the lack of consensus among

the commenters on the technical details of the Consumer Choice

alternative. The Department asked several specific questions about how

to implement such an option in the way least disruptive to the

industry. The answers received further reflected the uncertainties and

disruptions that would be created by imposing the Consumer Choice

alternative and helped convince the Department that such an approach is

not feasible. Since the Department is not adopting the Consumer Choice

alternative in this final rule, the responses received to a number of

the questions raised in the proposed rule do not merit detailed

discussion, but a brief summary of the comments in response to these

questions is provided below to convey the divergent opinions on this

subject.

1. The Department asked Question 7, which was designed to elicit

comments on when the appropriate time would be for the originator or

servicer to provide the borrower the disclosure, if the Consumer Choice

alternative were to be adopted. The commenters were fairly evenly

divided on whether the disclosure should be provided and the

[[Page 3228]]

selection made before closing but after underwriting or before

underwriting. Thirteen commenters simply indicated sometime before

closing, whereas 12 commenters indicated it would have to be before

underwriting. Seven commenters specifically indicated that the

selection would affect underwriting, whereas three commenters

specifically indicated that the selection should not affect

underwriting.

2. The Department asked Question 8, which was designed to elicit

comments about whether the Department should prescribe a disclosure

format if an approach were adopted in which the borrower's preference

for installments or annual disbursements were controlling. There was

general agreement that the Department should prescribe the format (20

commenters supporting prescribing it, with only 4 opposed). However,

there was disagreement over what the disclosure should say. Six

commenters supported the disclosure the Department had proposed, if one

was to be mandated. Seven commenters, however, said it was too

confusing and/or unclear. Four criticized it for containing too much

information or being overwhelming whereas, two criticized it for not

including enough information.

3. The Department asked Question 9, which inquired what period of

time would be needed for servicers to be able to implement the Consumer

Choice alternative. Four commenters said it could be implemented in

less than 12 months, 9 commenters indicated 12 months or more, 2

commenters said 18 to 24 months, and 4 commenters estimated it would

take 24 months.

2. Rejection of Servicer Flexibility Alternative

The preamble to the proposed rule explained that the Department

perceived this alternative as being the least intrusive regulatory

approach for the Department to take and providing the greatest

flexibility to servicers, while leaving servicers free to accommodate

borrowers with a particular preference, as long as the borrowers'

preferences were in accordance with the normal lending practice of the

lender and local custom and constituted prudent lending practice. The

Department noted that the disadvantage of this alternative is that it

would not guarantee that servicers would accommodate the preferences of

individual borrowers and, therefore, it provided less choice for

borrowers.

The Department has decided not to adopt the Servicer Flexibility

alternative. Most commenters did not favor such an approach. The

Department decided that there is no reason to adopt this approach and

that it would not necessarily be best for the consumer.

3. Rejection of Prohibiting Switching Disbursement Methods Without

Borrower's Consent

While the Department would have legal authority to impose a

restriction against switching disbursement methods without the

borrower's consent as part of the Secretary's rulemaking authority, it

has decided not to do so. The types of costs and burdens associated

with such a restriction are unwarranted. Therefore, this final rule

does not contain this restriction as part of the approach adopted.

E. Clarifications

In issuing this final rule, the Department wishes to address

several questions from commenters that will clarify the rule.

1. Selecting From Among Various Installment Plans Offered

Several commenters requested clarification of the servicer's

obligations when a taxing authority offers several different

installment plans. In such circumstances, the Department encourages the

servicer to use the installment plan that results in the lowest closing

costs for the consumer. However, the servicer is free to make

disbursements according to any installment plan offered by the taxing

jurisdiction so long as the selection complies with the normal lending

practice of the lender and local custom, and the installment plan

selected constitutes prudent lending practice. The servicer may also

make disbursements according to any installment plan offered by the

taxing jurisdiction to which the servicer and borrower may mutually

agree, on an individual case basis.

2. The Size of the Discount Does Not Matter

One mortgage company commented that the Department should make the

application of the Keep, But Clarify, Current Requirements approach

more consistent by establishing a guideline on when to switch to annual

disbursements to take advantage of a discount. One tax service

indicated that when the payee offers a choice between installments and

annual disbursements at a discount, the Department should either

require maximum discounts be taken or set a threshold and require the

servicer to disburse to obtain any maximum discount meeting or

exceeding that minimum.

In its proposed rule, the Department asked Question 6, which

specifically solicited comments on whether the size of an available

discount should matter and, if so, how. Fifteen commenters--11

originators/servicers, 1 trade association, 2 tax services, and 1

financial software company--indicated that the size of the discount

should make a difference under the rule in some fashion. Eight

commenters indicated that the rule should provide that if the discount

offered meets a Department-determined threshold, the servicer must

disburse annually to obtain the discount. Three commenters indicated

that the rule should provide that the servicer is free to decide if the

discount is large enough to make it worthwhile to make disbursements in

such a way as to collect the discount.

Among those who favored making the size of the discount matter

under the rule, there was no agreement on the best approach to setting

the discount threshold that would trigger application of one rule or

another. Five commenters opposed tying the discount threshold to a

market rate, while only one supported this approach. Five commenters

favored, but two commenters opposed, a ``reasonable servicer''

standard. One large tax service commented that not just the size of the

discount, but several other factors, affect the value of the discount

to the consumer, such as the rate of interest (if any) paid on escrow

accounts, market interest rates, and the borrower's income tax rate.

In contrast, 16 commenters--15 originators/servicers and 1 trade

association--indicated that the size of the discount should not make a

difference under the rule. These commenters indicated that such

consideration would present an additional burden and cost to calculate

the size of the discount and that discounts are beneficial to the

consumer regardless of the size.

The Department has not adopted the approach of making the size of

the discount a determinative factor in which disbursement method the

servicer should use. There is no apparent way to arrive at a reasonable

and acceptable guideline. Rather, the Department's approach in this

rule allows latitude to the servicer, while encouraging the servicer to

follow the preference of the borrower.

3. Application of Rule to Other Escrow Items

Two originators/servicers commented that this rule should clarify

that the Department's policy of favoring installments only applies to

taxes, not other escrow items such as hazard

[[Page 3229]]

insurance. One of these commenters added that this rule should clarify:

(1) that servicers should disburse mortgage insurance payments monthly

or annually; and (2) that hazard insurance payments should be disbursed

annually or as billed by the insurer, and if discounts are available

for annual disbursements it should be disbursed annually.

Under this final rule, the only specific requirements for choosing

between annual and installment disbursements pertain to property taxes,

not other escrow items such as hazard insurance. For escrow items other

than property taxes, if a payee offers a servicer a choice between

installment or annual disbursements, the servicer is required to make

disbursements by a date that avoids a penalty. The servicer, however,

is otherwise free to make disbursements on such disbursement basis

(annual or installments) and disbursement date as complies with the

normal lending practice of the lender and local custom, provided that

the selection of each such basis and date constitutes prudent lending

practice. The reason for distinguishing property taxes from other

escrow items is explained in Part V(B) of this preamble, above.

4. No Preemption of State Law on Installment Option

Two commenters requested clarification of whether RESPA preempts

State law in such a way as to require that States offer an installment

payments option to servicers, or if they currently only offer that

option to individual borrowers. The answer to that question is that

RESPA does not so preempt State law. Whether taxing jurisdictions

should make an installment option available to servicers is a matter of

State law, not RESPA.

5. Disbursing Annually Instead of in Installments When There is no

Discount if a Choice is Offered

One commenter, a Wisconsin bank holding company, raised a concern

regarding escrow accounts in Wisconsin, stating that servicers should

be able to make tax disbursements in an annual disbursement rather than

installments, if a choice is offered, even if there is no discount for

annual disbursements. The commenter represented that this was partly to

protect the servicer's lien, which becomes effective on the first of

the year in which the taxes are billed, and partly to give the borrower

the benefit of tax deductions for the current year. The commenter

explained that in Wisconsin, taxes are billed in November and can be

paid in two installments in the following January and July. In

addition, State law requires the servicer to issue a joint check to the

borrower and the taxing authority by December 20, or give the borrower

three options: (1) Pay in full by December 31 if the tax bill is

received by December 20, (2) pay the full tax when due (January and

July installments), or (3) issue a joint check to the borrower and

taxing authority by December 20. If the servicer offers the three

options, the servicer is required to follow the borrower's preference.

The commenter asserted that for the Department effectively to

prohibit the December payment would conflict with the Department's

prior guidance set forth in the preamble to the February 15, 1995 rule

(60 FR 8813, second column), which specifically allowed the practice.

The commenter further argued that a substantial change in

interpretation would undercut servicers who relied on the Department's

prior advice, would force servicers to disregard State law, and would

negatively impact on borrowers' tax deductions.

In response to this and other comments, this final rule adds a

provision to the regulations (Sec. 3500.17(k)(4)) specifying that a

servicer and borrower may mutually agree, on an individual case basis,

to a different disbursement basis (installment or annual) or

disbursement date than that which would otherwise be prescribed under

the regulations. This addition should address the commenter's concern

and allow the servicer to comply with Wisconsin law.

VI. Payment Shock--Comments Received, Approach Adopted in This

Final Rule, Basis for Approach Adopted, Basis for Rejecting

Alternatives

A. Comments Received

Through the comments received on the proposed rule, the Department

gained a better understanding of the payment shock problem. A few

commenters pointed out that there could be other causes of payment

shock aside from those that the Department had described in the

preamble to the proposed rule. Citicorp pointed out that payment shock

can also be caused by rate adjustments to Adjustable Rate Mortgages

(ARMs), special tax assessments, and additional insurance coverage

selected by borrowers after closing.

The Department also learned more about how servicers have been

addressing the problem of payment shock. Eight originators/servicers

indicated that their practice is to notify borrowers ahead of time and

provide an opportunity to make voluntary payments ahead of schedule to

avoid payment shock. Seven originators/servicers indicated that they

offer consumers extended repayment plans, even beyond those required

under RESPA, to make up shortages that result from payment shock. Nine

originators/servicers indicated that they use short-year statements to

minimize payment shock, a practice that also is useful. Two

originators/servicers indicated that they simply notify borrowers ahead

of time that payment shock may occur but do not explain how to avoid

it.

The Department solicited comments to gauge the extent of the

payment shock problem. Four originators/servicers and one home builder

specifically commented that they agreed with the Department's

assessment that payment shock is a very significant problem that needs

to be addressed. One commenter estimated that roughly 50 percent of its

customers experience payment shock because 30 percent of its loans are

for new construction on which taxes are initially assessed on

unimproved property and then reassessed for the improvements; an

additional 20 percent of its loans have prepaid taxes.

The view that payment shock was a problem was implicit in the

comments of several others, such as a servicer who indicated that the

current regulations do not work because of difficult situations with

borrowers that arise when payment shock occurs. Every commenter who

stated a reason for opposing the Make No Change alternative indicated

that they opposed the alternative because it would not address the

payment shock problem and/or ignored that a problem exists. There were

13 commenters who made such a statement--10 originators/servicers

(including 1 of the 4 mentioned above), 1 trade association, 1 tax

service, and the home builder mentioned above.

Countrywide commented that payment shock is the most serious

problem caused by the existing escrow accounting regulations because it

leads to delinquency, hurts borrowers' credit, and may result in people

losing their homes. NationsBank commented that it results in an

inability to make additional payments in the second year, increases the

possibility of delinquent payments, and accelerated collection

proceedings, and causes consumers to lose confidence in their lending

institutions. Two other originators/servicers agreed with Countrywide's

assessment that the situation leads to a significant number of defaults

and foreclosures. Two commenters commented that when payment shock

[[Page 3230]]

occurs, borrowers unfairly blame their lenders and/or their builders

and closing agents. Two commenters commented that when it happens,

lenders are left having to carry shortages, sometimes for 24 to 48

months, and that this puts the lenders at risk. Countrywide indicated

that it is a particularly perilous situation when two or more risk

factors are present in a transaction (a condition known as ``layered

risk''), such as when payment shock is combined with an upward

adjustment in the ARM rate.

In contrast, seven originators/servicers questioned whether payment

shock was really a problem in need of fixing. A bank with a mortgage

lending subsidiary commented that while many consumers fail to plan for

payment shock, they are not really surprised by it and feel that the

problem has nothing to do with the servicer. A rural bank commented

that it is really a consumer education problem, a problem that will

happen regardless of whether there is an escrow account or not. A bank

holding company commented that it is not a significant problem, while a

federal credit union indicated it was a very infrequent problem. One

servicer requested that the Department wait until the transition period

expires on the 1994-1995 escrow rules before making any further

changes. Citicorp also questioned whether it is a real and on-going

problem and suggested waiting until 1998 to consider new requirements.

1. Comments on Consumer Choice

Only one commenter, the California Association of Realtors (CAR),

supported Consumer Choice. As with the Annual vs. Installment

Disbursements problem, the CAR commented that it favored approaches

that provide consumers with as much information as possible and the

opportunity, when fully informed, to make choices about the servicing

of their loans and the related impound/escrow accounting.

In contrast, 81 commenters opposed the adoption of Consumer

Choice--66 originators/servicers, 10 trade associations, 1 tax service,

2 financial software companies, 1 builder, and 1 person of unknown

professional interest. The most common reasons given included:

1. It would result in miscellaneous costs and/or administrative

burdens (e.g., would increase cost of servicing or be a burden on

closing, would create operational problems, would be complicated) (53

commenters--46 originators/servicers, 5 trade associations, 1 financial

software company, 1 builder).

2. It would be impractical (36 commenters), for reasons such as

servicers will not have or would find it difficult to get or estimate

the information needed to calculate the disclosure (30 commenters--28

originators/servicers, 2 financial software companies).

3. It would necessitate more customer service to explain choices

and answer questions for consumers (28 commenters--26 originators/

servicers, 2 trade associations).

4. Consumer Choice would require system and programming changes and

new software or additional programming (23 commenters--19 originators/

servicers, 4 trade associations). Two large lenders indicated that if

Consumer Choice were selected they would need in excess of 18 to 24

months from the issuance of the final rule to reprogram their computers

and develop new forms and procedures.

5. The specific costs and burdens of consumer disclosure, including

producing and mailing disclosures, soliciting preferences, processing

disclosures, tracking selections, and maintaining information on

selection should be avoided (19 commenters--12 originators/servicers, 6

trade associations, 2 financial software companies) or objections to

adding a new disclosure in general (5 commenters--4 originators/

servicers, 1 builder).

6. The additional cost would be passed on to consumers (21

commenters--16 originators/servicers, 3 trade associations, 1 financial

software company, 1 builder).

7. It would create consumer confusion, consumers would not be able

to make an educated selection, and it would impose a burden on

consumers to have to make such a choice (17 commenters--11 originators/

servicers, 4 trade associations, 1 financial software company, 1

builder).

8. There is no need for it (14 commenters) for reasons such that no

consumer benefit or no significant consumer benefit would result (10

commenters--6 originators/servicers, 4 trade associations).

9. It would necessitate multiple sets of closing documents to

accommodate possible choices or otherwise interfere with the correct

preparation of closing documents (eight commenters--five originators/

servicers, one trade association, one financial software company, one

builder).

10. Additional training of staff would be required (eight

commenters--six originators/servicers, two trade associations).

Several commenters commented specifically about the proposed

prohibition against servicers switching accounting methods without the

borrower's consent, which was one element of the Consumer Choice

alternative. Only one commenter, GE Capital, indicated that it

supported restricting changes to accounting methods when there is a

transfer of servicing. GE Capital's support, however, was conditioned

on the selection of the accounting method being limited to a one-time

choice at closing, the selection being limited to situations involving

new construction, and the regulations being clarified to provide that

payments (as opposed to methodology) could be changed in the event of

unanticipated changes to escrow items.

In contrast, seven commenters, including six originators/servicers

and one trade association, opposed the aspect of Consumer Choice

prohibiting servicers from switching escrow accounting methods. The

reasons given included the following: (1) It would chill or burden

sales of servicing rights (three originators/servicers, one trade

association); (2) it would pose an administrative burden (two

originators/servicers); and (3) it would impair value of servicing

rights (two originators/servicers).

In the proposed rule, the Department asked Question 2, which was

designed to elicit commenters' views on how to define a substantial

increase in disbursements from an escrow account, and how mortgage

servicers could go about determining whether bills paid out of escrow

accounts were expected to increase substantially after the first year.

Virtually all of the commenters that responded to this question focused

on whether a 50 percent increase was an appropriate threshold for

defining a substantial increase, as proposed.

Four commenters--three originators/servicers and one trade

association--supported using 50 percent as a threshold. One bank

holding company indicated that 50 percent was an appropriate threshold

but that the payment shock problem should only be addressed in

situations involving new construction. Most gave no reason for why they

believed 50 percent was an appropriate threshold, other than that it

seemed to be a reasonable approach. The National Association of Federal

Credit Unions (NAFCU) indicated that the approach would avoid

confusion.

In contrast, 21 commenters--17 originators/servicers, 2 trade

associations, 1 financial software

[[Page 3231]]

company, and 1 builder--opposed using 50 percent as a threshold. Many

of these commenters indicated that the Department should not set any

threshold for when an increase would be considered substantial, yet no

commenters favored offering alternatives to borrowers whose escrow

payments were not expected to increase substantially after the first

year, and 16 commenters (14 originators/servicers, 2 trade

associations) specifically opposed such an idea. The reasons for

opposing using 50 percent as a threshold and/or opposing any

Department-established threshold were similar. They included:

1. Servicers would not be able to estimate if the expected increase

was within the threshold (seven comments--six originators/servicers,

one trade association).

2. Even less than a 50 percent increase could be a problem for

borrowers (five commenters--three originators/servicers, one financial

software company, one builder).

3. It would be burdensome and/or costly to calculate if the

expected increase would meet the threshold (five commenters--four

originators/servicers, one trade association).

4. Servicers should be given more flexibility (two originators/

servicers).

The Department also asked Questions 2 and 7, which were designed to

elicit responses as to whether, if the Consumer Choice alternative were

adopted, the final rule should limit a borrower's opportunity to switch

escrow accounting methods. Sixteen commenters (14 originators/

servicers, 1 trade association, 1 financial software company) indicated

that they opposed allowing even a one-time choice to be provided to

consumers, but that if the Department chose the Consumer Choice

alternative anyway, it should be limited to a one-time choice, for

reasons such as the additional burdens and costs more opportunities to

switch would create. Several other commenters that were less clear in

their dislike of the Consumer Choice alternative, nonetheless took

clear positions against offering more than a one-time choice.

In contrast, only three commenters advised against having different

systems for different borrowers. One based its view on the additional

confusion it would create over options and management of the options.

Another based its opinion on the additional complications. A third

stated it would add to the programming, personal, and postage costs and

create more confusion.

2. Comments on Make No Change Alternative

A total of 46 commenters supported the Make No Change alternative.

Forty-two commenters--35 originators/servicers, 5 trade associations, 1

financial software company, and 1 person of unknown professional

interest--supported Make No Change as proposed. The MBA and a bank and

trust indicated that Make No Change was their second choice next to

Mandate First Year Overpayment; NAFCU also implied it was their second

choice.

Four additional commenters indicated they would support Make No

Change if Variation (A) were added to it. The proposed rule described

Variation (A) as follows:

(A) Require servicers to disclose to borrowers that it is

anticipated that they will have a substantial payment increase in

the second year, so borrowers will be less surprised when such an

increase occurs, but do not require servicers to indicate

specifically to borrowers methods of avoiding the shortage.

61 FR 46517.

Three of the 42 who supported the Make No Change alternative as

proposed also indicated they would support Make No Change with

Variation (A). In addition, two originators/servicers that recommended

alternatives instead of Make No Change also indicated that as part of

those approaches that it should be disclosed to the borrower that a

shortage is expected, but not the amount of the expected shortage.

One commenter who otherwise supported the Make No Change

alternative indicated that it was opposed to mandating any type of

notice, but indicated a notice similar to Variation (A) would be less

problematic than the type of disclosure that would be part of the

Consumer Choice alternative. The commenter observed that any disclosure

should be generic (no calculations) and advise consumers that: (1) The

amount of taxes for which escrow funds are being collected is based on

information available at time of closing about anticipated property

taxes for next year; (2) the amount could change especially for new

construction; and (3) the consumer should monitor the situation and

consult a tax advisor if the amount increases substantially.

Ten other commenters--eight originators/servicers, one financial

software company, one builder--specifically commented that they opposed

Variation (A). The primary reasons were that it would not be effective

at eliminating payment shock, and giving borrowers advance notice that

a payment increase may occur should be left to the originator/servicer.

The reasons the commenters gave for supporting the Make No Change

alternative as their second choice were similar to the reasons other

commenters gave for supporting it as their first choice. The reasons of

all the commenters who supported it as their first or second choice are

summarized below:

1. This approach would encourage good, voluntary practices to help

customers on an individual basis (25 commenters--22 originators/

servicers, 3 trade associations).

2. No change is needed because the current rule is adequate (four

commenters--three originators/servicers, one financial software

company).

3. It would not be disruptive (three commenters--two originators/

servicers, one trade association).

4. It would allow servicers to exercise good judgment (two trade

associations).

5. It would be flexible (two originators/servicers).

6. Providing consumers with a simple disclosure would give

consumers information to act in their own best interest (one trade

association).

In contrast, 13 commenters--10 originators/servicers, 1 trade

association, 1 tax service, and 1 builder--opposed the Make No Change

alternative. Each of these commenters stated that they opposed the

alternative because it would not address the problem and/or ignored a

problem that exists.

Other commenters supported other variations on the Make No Change

alternative. Two originators/servicers supported Variation (B).

Variation (B) would have required servicers to disclose to borrowers

that it is anticipated that they will have a substantial payment

increase in the second year, and to inform borrowers of the amount of

the expected shortage at the end of the first year and of the

opportunity to make additional payments to escrow ahead of schedule to

avoid payment shock. On the other hand, seven commenters--five

originators/servicers and two financial software companies--opposed

Variation (B) for reasons such as the burdens and difficulties

associated with trying to estimate the amount of a shortage that is

expected to result.

In the proposed rule the Department also solicited comments on the

following alternative. For each new account for which it is anticipated

that there will be a substantial payment increase in the second year

for one or

[[Page 3232]]

more escrow items, allow the servicer, with the consent of the

borrower, the option of calculating the escrow payments on a 24-month

basis. This would allow the servicer to look ahead to the second year

and estimate the payment that would be due, thereby mitigating the

deficiency or shortage after the first year, leaving a smaller

deficiency or shortage after the second year. (Using an escrow account

period of more than 1 year has precedent. See the treatment of flood

insurance and water purification escrow funds in Sec. 3500.17(c)(9).)

Under this option, since the amounts held in escrow would be greater

than allowed under section 10 of RESPA, it would be necessary for the

Secretary to invoke his exemption authority under section 19(a) of

RESPA (12 U.S.C. 2617).

Only eight commenters commented on this particular approach. Five

commenters supported it while three opposed it. The Department does not

believe it is a superior approach to that adopted in this final rule,

as discussed below.

The proposed rule also invited commenters to submit other

permissible approaches under RESPA that would better serve the

interests of the public and the intent of the statute, inviting

commenters to submit specific regulatory language to implement their

proposals. Fourteen originators/servicers and two trade associations

submitted a variety of additional alternatives, none of which appear to

the Department to be a superior approach to that adopted in this final

rule, as discussed below.

3. Comments on Mandate First Year Overpayment Alternative

Twenty-seven commenters--21 originators/servicers, 2 trade

associations, 2 financial software companies, 1 tax service, and 1

State lending agency--supported the Mandate First Year Overpayment

alternative. In addition, Citicorp indicated that the Mandate First

Year Overpayment alternative was its second choice to the Make No

Change alternative. Bank of America indicated it was its second choice

next to an alternative of its own creation, but only for new

construction and situations involving special tax discounts (e.g.,

reduced taxes for seniors, disabled, or veterans). GE Capital indicated

it was its second choice to the Make No Change alternative, but should

only apply if the increase will be due to taxes being based on the land

value only for the first year. If the increase will be due to items

paid prior to the first payment date, GE Capital favored a different

approach.

The reasons given for supporting the Mandate First Year Overpayment

alternative included the following:

1. This approach would avoid payment shock best and would result in

the fewest shortages (14 commenters--11 originators/servicers, 2 trade

associations, 1 financial software company).

2. It would be better for consumers (12 commenters--9 originators/

servicers, 2 financial software companies, 1 State lending agency).

3. It would increase consistency, standardization, and uniformity

(seven commenters--three originators/servicers, one trade association,

two financial software companies, one State lending agency).

4. It would require only minimal changes (four commenters--two

originators/servicers, two financial software companies).

5. It would be the least costly alternative to implement (one

originator/servicer, one financial software company).

6. It would be the fairest alternative (one originator/servicer,

one tax service).

In contrast, 36 commenters--32 originators/servicers, 3 trade

associations, and 1 person of unknown professional interest--opposed

the Mandate First Year Overpayment alternative. The reasons given for

opposing this alternative included the following:

1. It would not be in the consumer's interest to overpay and then

money get back; this would be unfair to the borrower (10 commenters--7

originators/servicers, 2 trade associations, 1 person of unknown

professional interest).

2. This alternative would be administratively burdensome or costly

(e.g., having to make constant refunds and explanations to consumer)

(six commenters--four originators/servicers, two trade associations).

3. It would run contrary to the Secretary's stated objectives (21

originators/servicers).

In the proposed rule, the Department proposed that as a variation

on Method C, the cushion could be calculated as one-sixth of the

estimated annual disbursements for the first year, instead of 2 months

of the escrow payments for the first year. Two originators/servicers

and a financial software company indicated that they preferred Method C

to the variation. One of these commenters, a bank holding company,

indicated that the variation would be far less effective at eliminating

payment shock, while another, a mortgage company, indicated the

variation would be more complicated for borrowers and for the industry.

No commenter indicated a preference for the variation.

Commenters also suggested several additional variations on the

Mandate First Year Overpayment alternative as their preferred approach,

such as limiting it only to situations involving new construction (five

commenters--four originators/servicers, one trade association) or

offering it even when less than a 50 percent increase in disbursements

were expected (four commenters--two originators/servicers, one

financial software company, one builder).

B. Approach Adopted in Today's Final Rule

Based on the comments received, the Secretary has determined that

there would be little value in rulemaking on the payment shock

``problem.'' The comments, in sum, do not indicate that the ``problem''

is uniformly accepted as such in the industry, there is little support

for the Department's prescribing a particular accounting method that

will result in overescrowing consumers' money, and there is no

agreement on the nature of any form that the Department would prescribe

for homebuyers to warn of the possibility of a substantial increase in

payments to their accounts.

During the rulemaking, however, the Department identified that

individual servicers do provide a written disclosure to borrowers when

they anticipate increased payments. The Department favors this approach

and believes that such a disclosure should be encouraged as a best

practice, without the Department prescribing the particular form.

The Department has decided to adopt, with modifications, the Make

No Change alternative. This final rule, therefore, continues the

current requirements for escrow analysis, even when the servicer

expects that the disbursements from the escrow account will increase

substantially after the first year. This alternative will not prevent

payment shock in all instances. Under the final rule, however, as in

the past, servicers may disclose the problem to borrowers, and

borrowers may make voluntary overpayments to escrow accounts. Servicers

may also calculate short-year statements. Thus, some methods are

available to alleviate the payment shock problem, although they are not

required.

This final rule does depart, however, from the Make No Change

alternative of the proposed rule in encouraging, on a voluntary basis,

the use of a consumer disclosure format concerning payment shock to be

given to consumers when

[[Page 3233]]

the originator or servicer expects that a substantial increase in

escrow payments will occur in the second year of the escrow account.

The Department has determined not to define a ``substantial increase.''

Instead, this rule leaves this determination to each originator or

servicer to apply sound business judgment.

This disclosure format, which is published as an appendix to this

final rule, will be available from the Department as a Public Guidance

Document at the address indicated in 24 CFR 3500.3. The format is

entitled ``Consumer Disclosure for Voluntary Escrow Payments'' to

clarify that when the originator or servicer provides the disclosure,

the consumer may choose whether to make higher payments during the

first year to reduce or eliminate the monthly payment increase in the

second year. The disclosure contains the following information:

The bills paid out of your escrow account are expected to

increase substantially after the first year[.] [because

______________]. Under normal escrow practices, your monthly escrow

payment in the second year could be much higher than in the first.

You may voluntarily choose to make higher payments during the

first year to reduce or eliminate the monthly payment increase in

the second year. If you are interested in doing this, contact:

----------------------------------------------------------------------

The instructions to the preparer explain that the blank provided is

to indicate whom to contact for further information on making voluntary

overpayments during the first year, including the mailing address, fax

number, e-mail address, and/or telephone number of the contact. The

terms ``reserve'' or ``impound'' may be substituted for the terms

``escrow account'' or ``escrow'' to reflect local usage.

While use of the disclosure is not mandatory, providing the

disclosure to consumers is a best practice that the Department

encourages originators and servicers to follow. The Department is

publishing this format at the end of this rule as an appendix for the

convenience of the reader. It will not be codified in the Code of

Federal Regulations.

The recommended format published with this final rule, in addition

to providing notice that payment shock may occur, also indicates that

payment shock can be avoided by making additional payments to the

escrow account, and suggests that the consumer ask the appropriate

originator or servicer for more information. While simply informing

consumers of the potential of payment shock and providing information

on how to avoid it may not lead the consumers to take actions to avoid

it, the information will benefit some consumers and may lead them to

request voluntary borrower and servicer agreements to make additional

payments to avoid shortages.

To provide clarity to servicers, this rule adds a new provision (24

CFR 3500.17(f)(2)(iii)) regarding funds deposited as a result of such

voluntary borrower and servicer agreements. The provision states that

the voluntary agreement is for a 1-escrow-account-year period, although

successive agreements are allowed. By receiving higher escrow payments

into the account, the ending balance will be greater, thus lowering or

eliminating the anticipated shortage at the time of the next analysis.

At the time of the next escrow analysis, Sec. 3500.17(f) regarding

shortages, surpluses, and deficiencies will continue to apply, and may

not be changed by any voluntary agreement.

C. Basis for Approach Adopted

The comments received served to confirm that the Make No Change

alternative, with some modifications, is a workable solution to this

problem. Based on its review of the comments, the costs and burdens

associated with any other approach are simply too great compared to the

benefits. There is no strong evidence that additional regulation is

needed at this time to address the problem. Existing procedures are

adequate to avoid payment shock. This rule encourages originators and

servicers to inform consumers of the potential problem and allow them

to use existing procedures to avoid the problem if they so desire.

This final rule is similar to Variation (A) of the Make No Change

alternative in the proposed rule, which was recommended by several

commenters. As recommended by commenters, use of the format is not

mandatory, but the recommended format is similar to that which was

suggested by several commenters. Heeding the objections of several

commenters, the recommended format does not call for an estimate of the

amount of a shortage that is expected to result. Several commenters

urged that the final rule leave the decision of whether to give

borrowers advance notice that a payment increase may occur to the

originator/servicer. In response, this final rule leaves this

determination to each originator or servicer to apply sound business

judgment in deciding whether to provide the disclosure; it does not

make the disclosure mandatory or define a ``substantial increase.''

The Department intends this final rule to encourage more

originators and servicers to adopt practices that will ensure that

consumers are informed of the payment shock problem and given the

opportunity to avoid it. These practices include:

Notifying borrowers in advance and providing an

opportunity to make voluntary payments ahead of schedule to avoid

payment shock. The Department encourages servicers to use the

recommended format published today to notify borrowers of this

potential problem when the originator or servicer, in applying sound

business judgment, believes that payment shock is like to occur.

Offering consumers extended repayment plans, even beyond

those required under RESPA, to make up substantial shortages associated

with payment shock.

These two practices are examples of the types of best practices

that some originators/servicers in the industry are using today, even

without a Government requirement. The Department encourages servicers

to adopt these practices so that they will become more widespread.

D. Basis for Rejecting Alternative Approaches

1. Rejection of Consumer Choice Alternative

While the Department believes it would have legal authority to

impose Consumer Choice, including the prohibition against the servicer

changing escrow account methods, as part of the Secretary's rulemaking

authority, it has decided not to do so. The types of costs and burdens

associated with such an approach are prohibitive at this time.

The Department was also influenced by the obvious lack of consensus

among the commenters as to how to work out the technical details

associated with the Consumer Choice alternative. The Department asked

several specific questions about how to go about implementing such an

alternative in the way least disruptive to the industry. The answers

reflected the uncertainties and disruptions that would be created by

imposing the Consumer Choice alternative, and helped convince the

Department that such an approach is not feasible. Since the Department

is not adopting the Consumer Choice alternative in this final rule, the

responses received to a number of the questions raised in the proposed

rule concerning this issue do not merit detailed discussion, but a

brief summary of the comments in response to these questions is

provided below to give a

[[Page 3234]]

sense of the divergent opinions received:

1. The Department asked Question 5, which was designed to elicit

views on when the appropriate time would be for the originator or

servicer to provide the borrower the disclosure, if the Consumer Choice

alternative were to be adopted. The commenters were nearly evenly

divided on whether the disclosure should be provided and the selection

made before closing but after underwriting or before underwriting.

Eight commenters simply indicated sometime before closing, whereas six

commenters indicated that it would have to be before underwriting. Two

originators/servicers and one tax service indicated that no matter what

time was selected, problems would arise. Five commenters specifically

indicated that the selection would affect underwriting because it could

affect the funds needed to close, whereas one mortgage lending

subsidiary of a bank stated emphatically that it ``should have

absolutely no bearing on the loan underwriting or approval process

since the borrower must qualify based on a tax escrow payment

calculated on fully assessed value.''

2. The Department asked Question 6, which asked whether the

Department should prescribe a disclosure format if an approach were

adopted in which the borrower's preference for a particular escrow

accounting method were controlling. Although there was general

agreement that the Department should prescribe the format (15

commenters supporting prescribing it with only 2 opposed), there was

disagreement over what the disclosure should say. One commenter

supported the disclosure the Department had proposed, agreeing ``with

the simplicity of the proposed format.'' Seven commenters, however,

said it was confusing and contained too much information, whereas two

commenters criticized it for not including enough information.

2. Rejection of Mandate First Year Overpayment Alternative

While the Mandate First Year Overpayment alternative was extolled

by some in the industry as the best solution, there was no consensus

even within the industry for this approach. Thirty-two originators/

servicers and 3 trade associations opposed it, while only 21

originators/servicers, 2 trade associations, 2 financial software

companies, 1 tax service, and 1 State lending agency supported it. The

Department is persuaded that it is simply not in the consumer's

interest to mandate overpayment into escrow accounts, even if consumers

ultimately get the money back. Mandating escrowing beyond the

limitations of the statute would be unfair to borrowers. Consumers

should not be forced to tie up money unnecessarily in their escrow

accounts and may prefer to invest the money elsewhere or use it for

other more pressing purposes. There is no compelling case for the

Department to exercise its exemption authority for this purpose. Nor

would such an approach be consistent with the Secretary's stated

objectives for escrow accounting.

VII. Single-Item Analysis With Aggregate Adjustment Problem--Comments

Received, Approach Adopted in This Final Rule, and Basis

A. Comments Received on Revision Proposed

The Department sought comments from the public on this proposal, as

well as other approaches that would be permissible under RESPA and

might better serve the interests of the public and the intent of the

statute. The Department also invited commenters to submit specific

regulatory language to implement their proposals.

A significant number of commenters, including servicers and trade

associations, found the proposal to represent a functional or

acceptable solution. The MBA, while favoring the proposal, indicated

that some of its members were concerned about settlement agent

confusion from the change. Those members opposing the change indicated

that they make use of the 45-day period within which the initial

analysis must be delivered, so they did not share the concern over

presenting two different accounting methods. During the Department's

development of the proposed rule, Federal Reserve Board staff had

indicated that it had no objection to the approach in the proposed

rule, inasmuch as the PMI number for APR calculations would otherwise

be available.

On the other hand, a number of major lenders and/or servicers

opposed the change. For example, Chase Mortgage stated that it was not

beneficial for consumers or servicers, since consumers would lose the

ease of a single statement from which amounts can be reconciled, and

servicers would have no viable audit trail to indicate how the initial

deposit was calculated to resolve later differences or discrepancies.

Bank of America's comments were similar. A number of other commenters

decried a retreat from uniformity (the original premise of the 1994-

1995 escrow rules) that allowing options among servicers would produce,

and indicated that options affected the ease of servicing transfers. On

a tangential point, the American Escrow Association wanted continued

clarity that the settlement agent action reflected instructions

received, not independent activities of the settlement agent.

B. Approach Adopted in This Final Rule and Basis

The Department carefully reviewed the comments and considered them

in view of the mandate issued to the Department and the Federal Reserve

Board under legislation enacted September 30, 1996 to re-examine RESPA

and TILA disclosure requirements. See sec. 2101 of the Economic Growth

and Regulatory Paperwork Reduction Act of 1996 (Title II of the Omnibus

Consolidated Appropriations Act, 1997, Pub. L. 104-208; approved

September 30, 1996).

It would be inappropriate to undertake a piecemeal and unilateral

revision of the HUD-1 and HUD-1A at this time. In addition, the

elimination of the aggregate adjustment from the HUD-1 and HUD-1A would

harm those who have already developed systems that rely on it for an

audit trail. There simply was no consensus for the change. Therefore,

this final rule does not contain any revision to the 1000 series

disclosures; servicers should continue to follow existing requirements.

On a related matter, this rule adds information to the footnote

instructions to Appendix C, in order to reaffirm a previous

clarification that instead of using aggregate accounting with no more

than a 2-month cushion, the reserves on the Good Faith Estimate may be

estimated by using single item accounting with no more than a 1-month

cushion (see 61 FR 46518, column 3, September 3, 1996).

VIII. Lead-Based Paint Disclosure Issue--Comments Received, Approach

Adopted in This Final Rule, and Basis

A. Comments Received on Revision Proposed

Commenters were almost evenly divided regarding the desirability of

adding the lead-based paint disclosures. Nine commenters--four

originators/servicers and five trade associations--indicated that they

supported or had no objection to the proposal. Most gave no reason.

Among those who did, the National Association of Federal Credit Unions

indicated that they supported the proposal because it would help

educate borrowers of their rights.

In contrast, eight originators/servicers opposed the proposal. One

lender indicated that by imposing the burden

[[Page 3235]]

of disclosure on the lender, the Department would be blurring the

responsibility of sellers to give lead-based paint disclosures required

by the EPA/HUD rule (implementing section 1018 of the Housing and

Community Development Act of 1992). The commenter noted that lenders

have never been required to disclose matters of law between sellers and

buyers. Six other originators/servicers presented similar or related

arguments.

Four originators/servicers indicated that providing a disclosure on

the GFE would be duplicative of other lead disclosures; one commented

that the HUD booklet ``Settlement Costs and You'' was a more

appropriate forum for this type of disclosure. Two originators/

servicers expressed concern that lenders would become involved in

lawsuits involving lead-based paint, and that the disclosure could be

interpreted as implying a lender duty in some future consumer class

action.

B. Approach Adopted in This Final Rule and Basis

Upon careful review of these comments, the Department agrees with

the commenters who believe that the lead-based paint disclosure need

not specifically be added to the GFE and the HUD-1 and HUD-1A as a

separate line at this time. This final rule continues the existing

requirement that the lead-based paint inspection fee be included on the

HUD-1 or HUD-1A if a lead-based paint inspection is either: (1)

required by the lender, whether paid outside of settlement (in which

case ``P.O.C.'' should be used) or at settlement; or (2) paid for at

settlement. The only change made by this rule is a clarification to the

instructions for the HUD-1. The current instructions indicate that

Lines 1301 and 1302 of the HUD-1 may be used for ``fees for survey,

pest inspection, radon inspection, lead-based paint inspection, or

other similar inspections.'' The instructions are being changed to

indicate that Lines 1301-1302 or any other available blank line in the

1300 series may be used for these purposes.

In addition, the Department has recently implemented several

programs to assist homebuyers in

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