The Rule of 78s

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            My father-in-law Sandy was a quiet, gentle man.  He’s passed away now, but his memory lives on in those of us who knew him well.  He left a lasting imprint on a large number of us, and he taught us many, many things. One of the minor things he taught me about was the rule of 78s.

Sandy was an engineer.  He sometimes did things that were perhaps unimaginable to those of us who had not been through the School of Engineering.  One of those feats was to perform the interest calculations on his new car loan.

If memory serves, Sandy bought a new Toyota.  He bought it on credit.  After he had received a few statements and made a few payments, Sandy actually got out his mathematical tools (a slide rule perhaps?) and he calculated the amount of interest that was being credited to his account with each payment that he had made.  Sandy wasn’t afraid of numbers.  I sometimes caught him reading books that had strange mathematical symbols.  So in truth, he probably did these calculations as much for fun as he did to check up on the vehicle lender.

Anyway, Sandy’s calculation showed that the lender wasn’t crediting his payments properly.  In other words, Sandy’s principal balance was not going down as quickly as it should have been.  The lender was applying too much of the payment towards interest and not enough of each payment to principal.

I remember Sandy coming down the hall shaking his head.  He told me what the problem was.  He said that he had discovered this problem with the lender’s calculations, and so he contacted them to let them know they were incorrectly crediting his payments, and that his principal balance should actually be lower than what was shown on his statements.  That was when he learned about the “Rule of 78s.”  The lender’s representative told Sandy that the interest was being correctly calculated, but that it was being calculated according to the “Rule of 78s” which meant, in essence, that the interest on the front end of the loan was being paid off at a higher rate than it would be at the end of the loan.  Apparently, when the Rule of 78s is applied, everything works out well in the end if the loan is paid over its full term on the basis stated in the loan papers and if the loan isn’t paid off early.  But if the loan is paid off early, then the lender collects a bit more interest than it would otherwise.

Sandy wasn’t happy about it.  But he had signed a contract that allowed the lender to credit his payments according to the Rule of 78s, and so Sandy figured out he would just pay off the car according to the loan terms (again, if memory serves, he subsequently decided to pay it off early).

I subsequently bought a car on credit, and sure enough, there on the loan application was a box that could be checked so that the “Rule of 78s” could be applied.  However, the box wasn’t checked, and so it wasn’t used in connection with my car loan.

Exactly what is the Rule of 78s? I couldn’t find an article in Encyclopedia Brittanica that discussed it.  But there is an article in Wikipedia.  The URL is   Reading this article?  It helps if you like math.  If you really, really like math, then you might enjoy the Wikipedia article on Rule of 72 Interest Calculations at   I was interested to find that some years ago a federal law was passed that prohibited use of the Rule of 78s on consumer transactions with a term of more than 61 months.  This law is found at 15 U.S.C. 1615 (here’s the link:   Most car loans are 60 months (or less) and so this federal law may not prohibit the use of the Rule of 78s on car loans.

How does this apply to the purchase of housing?  Most home loans are made for a term of more than 5 years (or 60 months).  Since 15 USC 1565 prohibits the application of the Rule of 78s to loans with a term of more than 61 months, most home loans would never be properly subject to the Rule of 78s.

Proper calculation and application of interest can be complex.  Persons with any question about their loan, whether about the interest or otherwise, should contact a trained professional.

Keeping Your Checks

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           I recently spoke to an accountant about tax problems.  He pointed out that there are certain statutes of limitations as to tax disputes with the IRS, and that due to these statutes of limitations many accountants advise people to keep their financial records for at least seven years.

Makes sense.  But what’s the preferred time to keep financial records? Is it five years? Seven years?  Something more?  Something less?

Well, it all depends on why the records are being kept. If you want to feel a bit more snug in your home, then of course it’s possible to fill closets and file drawers with old financial records.  At least then you know what you’ve bought, saved, and spent.  I remember my mother showing me her account ledgers from the 1940’s.  It was delightful to see what she paid for a quart of milk in, say, 1942.  And her household expenses were far less when my dad was teaching typing for 25 cents an hour.  It can be a great nostalgia trip to look back and remember those days when bread cost 10 cents a loaf, an ice cream cone was 10 cents, a candy bar was 5 cents and a gallon of gas was 19 cents (I don’t think of myself as being old, but even I can remember those prices).

So nostalgia aside, why is it a good idea to keep old financial records for a period of time, or is it even necessary at all?

If you never have a future dispute or misunderstanding with the IRS, or your lender, or anybody else, then you may never have a need to keep any records.  But the several statutes of limitations are written, in part, because old records tends to get discarded after a period of time.  The thinking is that it’s unfair to allow old, stale claims to be made against people after they’ve tossed all their old records and can’t prove much through their documents.

But the follow on to that line of thinking is that people do tend to keep their written financial and other records for some period of time.  And there is good cause for this.  If there’s a financial dispute or a claim of any kind, then much of the evidence may well be centered on financial records.  For example, an accountant might say that the IRS has a period of several years in which they can come back and challenge a tax return.  Just because the IRS doesn’t say something now doesn’t mean they can’t in the future.  If a taxpayer can’t produce records to verify the deductions claimed, then that taxpayer could find themselves in a very difficult (and potentially expensive) situation.  If a borrower claims to have made payments that can’t be proven later, then it can be both difficult and expensive to resolve a dispute that might have easily been settled if the proper documents were available.

How long does a bank keep copies of checks?  Some banks will tell you that they only keep them for a period of a few years.  So what happens if there’s a dispute?

Over the past few years, there have been a number of reports about banks not being able to find an original loan agreement, or an original promissory note.  What happens if the bank modifies a loan agreement – but if nobody can find that modification agreement?  Loans get paid back over a period of 30 years or more.  There can be a lot of water going under the bridge in 30 years.  If at the end of the day the Bank says that one amount is still due to pay off a loan, but the borrower says it’s something less, then how can such a dispute be resolved?

The best way to resolve such a dispute is through producing a copy of the signed loan agreement, a copy of the signed loan modification agreement, and by producing copies, front and back, of each and every check submitted in payment.  That’s a bit of an administrative feat – but it sure makes things easier if there’s a dispute about how much has been paid.  Borrowers should also review their statement each month to ensure that their loan payments are being properly credited, and should immediately raise a protest if the numbers aren’t correct.  And copies of these statements should also be saved, front and back.

And what if a borrower wants to start making extra payments each month to pay off their loan early?  In such a case it’s certainly a good idea to keep a copy of the canceled checks – just in case the extra payments aren’t properly credited to the account. Early payments can have a profound effect on the interest charged on a loan – but only if the extra payments can be documented, or proven, in the event of a dispute.  Some loans provide for a fee or a penalty to be paid for the privilege of making early payments.

Proper calculation and application of interest can be complex.  Persons with any question about their loan, whether about the interest or otherwise, should contact a trained professional.

Second Loan Interest Rate Reflects Higher Risk to Lenders

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            Most homeowners are familiar with the concept of Homeowner’s insurance. This kind of insurance will typically insure the house against loss or damage.  If a home is damaged by fire or storm, most homeowners would know to call their insurer to report the damage and make a claim.

But some homeowners may not be familiar with mortgage insurance, also know as PMI.  This insurance typically provides coverage in the event of a mortgage default or foreclosure.  This insurance is typically designed to benefit lenders, but not homeowners. If a homeowner defaults on their loan, and their property is sold in foreclosure, then PMI mortgage insurance is designed to compensate the lender for the loss to the lender in the event the property sells for less than the amount of the loan.

Twenty years ago it seemed like many lenders were routinely requiring borrowers to purchase mortgage insurance. The PMI insurance payment was a monthly charge that borrowers paid in addition to their mortgage loan  payments of principal and interest.  In the event of a default or foreclosure, the borrower never received any payout from the insurer.  Instead, any payout went only to the lender.  In more recent years, it seems like lenders have often used a second loan to replace mortgage insurance.  Instead of requiring borrowers to purchase mortgage insurance, lenders often make two loans to borrowers.  The first loan, at a lower interest rate, often covers the majority of the house purchase price.  The second loan, at a higher interest rate, covers something like 10 to 20% of the price of the house.  If the market turns down, then this second loan is at a higher risk of not being repaid.  This increased risk is usually reflected in the higher interest rate charged by the lender.   Because the second loan is the one most at risk, such lenders have considered it unnecessary for borrowers to pay for PMI insurance when the property is purchased with two loans.

Short Sale Is Only One of Several Options

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My wife and I bought our first home in 1989.  That was a banner year for real estate – in more ways than one.  The real estate market had experienced appreciation of close to 20% each year during the previous five years.  As a result, we paid almost exactly double the price that our seller had paid five years earlier.

This got my attention.  We’d paid more than we could afford at the time, and the monthly loan payments were a real challenge.  But given the rapid increase in prices I’d seen over the preceding years, I figured that if we needed to get out, then we’d sell at a profit.  Little did I anticipate that we’d hold the house for 7 years, do many improvements, and then sell at a loss.

For many years afterwards I’d mention to friends and acquaintances that we had lost money in the California real estate market.  Nobody could believe it.  All around us prices were escalating ever upwards, and the thought of losing money in real estate seemed like an impossibility.  I was the only person I knew of who had lost money in the California real estate market.

Fast forward to 2010.  I’ve been practicing real estate law now for over 20 years.  My first foreclosure matters were in 1987, and after that I hadn’t really worked on any for close to 15 years.  And then the market turned downwards.   I now consult on short sale and foreclosure matters on nearly a daily basis.  The white-hot appreciation of five years ago is gone, and homeowners are just trying to find out the best way to walk away from their homes – with most of them experiencing substantial loss.  It’s a difficult time.

It’s difficult to work on scraping together a down payment, then experience the excitement of moving into a new home, and make improvements only to find out years later that the home is worth half of what you paid for it.  Some homeowners choose to stay in their homes even in these situations.  But other homeowners are transferred in their jobs or they experience employment setbacks.  These owners have limited options with respect to their homes.

Many people are of the opinion that the best way to walk away from their home is through a short sale.  But that’s not always the case.  Liability issues can linger after a short sale – even though homeowners may believe that they are done with the property once it’s sold.

Mortgage, short sale and foreclosure law is complex.  These subjects involve complicated tax and liability issues.  Sometimes the best approach for a homeowner in distress is to short sale a property, but other times foreclosure is a far better option.  Bankruptcy is the best option for some owners.

Because of the complex issues and law involved, homeowners are prudent when they seek competent, qualified, experienced tax and legal advice.

Sold-Out Junior Loans Can Be A Concern

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Last week’s column described how California has two types of homeowner loans with respect to personal liability.  Such loans are either “recourse” or “non-recourse.” The distinctions between these two types of loans can make a significant difference on whether or not a buyer ends up with personal liability following a foreclosure.

Homeowners with two loans on their properties are particularly at risk with respect to personal liability.  If a borrower has a second loan that is a “recourse” loan and if the first lender forecloses, then the       second lender will become a “sold-out junior.”  When this happens, the second lender will in most cases have the right and ability to file suit against the borrower for the full unpaid amount of the second loan.  However, until the first lender forecloses, the second lender can’t file suit.  This is because as long as the second loan is secured by a mortgage or deed of trust, the lender can’t file suit directly on the loan.  Instead, the second lender is required to foreclose as long as the second loan is secured by a mortgage.

Both first and second lenders must first “exhaust” their security by foreclosing before they can ever seek personal liability against the borrower.  And because some foreclosures don’t result in personal liability by the borrower to the foreclosing lender, many borrowers who have only one loan on their property find that they don’t have personal liability to their lender following a foreclosure. (However, there can be exceptions).

The situation is different when there are two loans.  When the first lender forecloses, the deed of trust of the second lender is “wiped out” but the loan from the second lender isn’t “wiped out.” As a result of a foreclosure by the first lender, the borrower is exposed to full personal liability on any recourse loan from the second lender.

Some second lenders actually do file suit against borrowers following foreclosure by the first.  If the borrower cannot pay or settle the claim of the second lender, then sometimes these borrowers end up in bankruptcy.  With proper advance planning, these situations can sometimes be avoided.  Borrowers are therefore wise to obtain competent, experienced legal counsel before committing themselves to a course of action with their lender workout negotiations.

Title Insurance Can Be Significant

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I’m all for saving a nickel.  Problem is, sometimes there’s a good reason for spending a nickel.  So sometimes trying to save a nickel can, well, backfire – especially when it comes to legal matters.

Sometimes property can be purchased at a very favorable price at a foreclosure sale.  But there are risks in buying such properties.  Purchasers usually don’t have the opportunity to inspect the interior of a property before buying it at a foreclosure sale.  There usually are no disclosures made in a foreclosure sale, so there can be unknown, hidden defects lurking in a property that don’t come to light until after the sale is complete.  When unknown problems exist, foreclosure purchasers may have no recourse but may have to suffer any loss that comes with unknown problems or defects.

There can also be title issues with foreclosed properties.  Sometimes a property will have several liens that affect it.  When buying property at a foreclosure sale, it’s really, really important to know which liens are senior and which ones are junior.  When a junior lienholder sells a property at a foreclosure sale, then the property usually remains subject to any senior liens.  Foreclosure buyers who don’t know about senior liens can find themselves in big trouble if they think a property title is clear of senior liens but it isn’t.

Here’s a case in point.  A real estate investor decided he’d get involved in buying properties at foreclosure sales.  He needed to know the condition of title before he made bids on properties at these foreclosure sales.  He knew somebody at a title company who was willing to give him title information on a very, very informal basis.  When a property would come up for sale, this investor would email his contact person at the title company, and ask if title would be clear after the foreclosure sale.  His contact person would send a reply email that either said “yes” or “no.”

This investor identified an expensive property that was scheduled for foreclosure sale.  The investor emailed his contact person and asked if the title would be clear of liens following the foreclosure sale.  His contact person responded with a “yes.”  However, this information was incorrect.  There was actually a lien for 1.6 million dollars that would still be on the property after the foreclosure sale.

At the foreclosure sale, the investor entered a bid for $1,000,000.01 and got the property.  Unfortunately, he only found out after the sale about the lien for 1.6 million dollars.  As a result of this unknown lien, he lost one million dollars.

The investor sued the title company, and claimed that he lost his million dollars because the title company had given him bad information that he relied on.  But the Court ruled that the title company had no liability to the investor because it hadn’t issued a title policy or a title abstract.  The Court found that title policies or title abstracts are specifically intended to be relied on, but the Court found in this case that the title company had no liability for this informal information give to the investor.  In other words, the investor saved a little bit of money by not buying a policy of title insurance.  But this small saving eventually turned into a million dollar loss. The case is reported at Soifer v. Chicago Title Company (2010) 187 Cal. App. 4th 365.

In this case, the title company wasn’t liable. But that might not be the situation in every case. Title insurance can be complex.  Persons without specialized training or expertise shouldn’t make their own determination about whether or not they need title insurance in a given situation, or what kind or amount of insurance they need, but should instead work with an experienced, trained professional.

  1. Parties to real estate transaction often try to save a nickel in transaction costs.  Sometimes these cost savings can be useful.  But they sometimes involve risks that can be significant.

Two Words Can Be Expensive

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            You just never know.

These days, there are many, many loans that are not being repaid.  The large majority of foreclosures undoubtedly happen because a loan was not repaid.  But what happens when a loan is in fact repaid, but the lender claims it wasn’t?

The United States Supreme Court ruled on just such a case in Jerman v. Carlisle (2010) 130 S. Court 1605.  In the Jerman case, a lawyer (who was acting as a debt collector) filed a lawsuit against a borrower.  The lawyer sought to foreclose a mortgage from a lender.  The complaint that was filed and served on the borrower included a Notice to the borrower that the mortgage debt would be presumed valid unless the borrower disputed the debt “in writing.”

The borrower’s lawyer sent a letter to the debt collector lawyer challenging the debt.  The lender eventually confirmed that the debt had been paid in full, and the debt collector lawyer dismissed the lawsuit.

After the debt collector lawyer dismissed the lawsuit, the borrower filed her own lawsuit against the debt collector lawyer for violation of the Fair Debt Collection Practices Act (which is sometimes known as the “FDCPA”).  The FDCPA is a federal law that contains certain steps that debt collectors must follow when collecting a debt.  According to the FDCPA, a debt collector must send a borrower a statement that a debt will be presumed valid unless the borrower disputes the debt within 30 days.  However, the FDCPA does not provide that the borrower must dispute the debt “in writing.”  Instead, the FDCPA only provides that the debt will be presumed valid unless the borrower disputes the debt.  Apparently, the borrower can dispute a debt by a telephone call or some way other than “in writing.”

The borrower’s lawsuit claimed that the debt collector lawyer had violated the Fair Debt Collection Practices Act by requiring that the borrower dispute the debt in writing instead of just disputing the debt.  The debt collector lawyer claimed that this mistake was a good faith error and that the debt collector therefore shouldn’t be liable to the debtor for violating the FDCPA.

The Supreme Court disagreed, and held that the debt collector lawyer could in fact be liable for violating the FDCPA by requiring that the borrower dispute the debt “in writing,” when the FDCPA didn’t require the borrower to dispute the debt “in writing.”

In this case, the phrase “in writing” consisted of two very expensive words.  Cases don’t usually get filed in the Supreme Court.  Instead, they almost always get filed in a trial court, and they usually reach the Supreme Court only on appeal.  In this situation, the borrower filed her lawsuit in Federal District Court, which eventually held that the debt collector lawyer wasn’t liable because the error was made in good faith.  The Court of Appeals for the Sixth Circuit agreed, and held that the debt collector lawyer wasn’t liable.  However, on further appeal the United States Supreme Court reversed the Court of Appeals and found that the debt collector lawyer could be liable for requiring the debt to be disputed “in writing.”  And that’s not the end of the story.  The Supreme Court didn’t render a final judgment in its opinion but instead sent it back to the lower court for further proceedings.

The FDCPA allows a court to award actual damages to a borrower. Where a violation is made through a good faith error, the FDCPA allows a court to also award a borrower up to one thousand dollars in additional damages.  In class actions, this additional damage award can be $500,000 or 1% of the worth of the debt collector, whichever is less.  But a debt collector can also be liable for a borrower’s attorneys fees,  which in this case could be very, very expensive.  (Where a lender violates the FDCPA with actual knowledge, the lender can incur civil penalties of up to $16,000 per day.)

Those two additional words “in writing” proved to be a very costly error for the debt collector.  But that is sometimes the nature of the law.  Words which are imprudently, or improperly, or unlawfully spoken or written can sometimes result in a big problem, and a costly situation.

Missed Deadlines Can Make A Difference

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            Cinderella got off easy.

She did.  She knew the score.  She knew she had to be home by midnight.  And she wasn’t.  And because she wasn’t home on time, everything fell apart.

But she still got the handsome prince.

It’s not like that with foreclosure.  Here’s a real life example.

A bank held a mortgage on real estate owned by a debtor.  The debtor defaulted on its payments.  The bank foreclosed.

A foreclosure sale was held.  A stranger appeared at the auction and bid $2,000 for the property.  No other persons appeared at the sale, and no other bids were submitted, so the bidder received the property for a total of $2,000.

As it turns out, a bank representative intended to make a bid at the sale, but this representative arrived late.  The sale was finished before the bank representative showed up. The bank’s representative asked the sheriff conducting the sale to invalidate the sale, but the Sheriff refused.

Here’s the rub: the property consisted of 57 acres worth 6.5 million dollars.  The guy who bought the property was prepared to pay ten million dollars for it. Instead, he got it for two thousand dollars.  The case is Amalgamated Bank v. Superior Court (2007) 149 Cal. App. 4th 1003.

If you were the bank representative, how would you like to take that news back to your boss at the end of the day? Your conversation might go something like this:

Boss: “So – how did the sale go today?  Did we get the 57 acres?”

Employee: “Well, there was a small problem.”

Boss: “Really?  What kind of a problem?”

Employee: “Well, the line at this donut shop was really long, and . . .”

You see how it goes.  The employee gets an opportunity to update their resume.  And the interview for their next job might go something like this:

Interviewer: “So, why did you leave your last job?”

Employee: “Well, there were these 57 acres and . . .”

Ouch.

Deadlines are important.  Sometimes the law is forgiving.  And sometimes it isn’t.

Loans are Complex

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Anybody who has borrowed money from a commercial lender knows that the stack of paper concerning such a loan is substantial.  There are often disclosures, Agreements, and all sorts of papers that accompany such a loan.  Most people seem to place them in a folder and tuck them somewhere deep in their filing system – the back of the garage, a tall filing cabinet, maybe a shelf in a closet somewhere.  Seems like most of the time the purpose for all of these papers isn’t really described in any detail – it’s just that the papers are there, they are part of the loan process, and they often must be signed or the lender won’t make the loan.  So at the end of the day, a borrower often ends up with a stack of paper, and often the borrower doesn’t have a good idea as to why these papers are necessary, or why the borrower has been asked to sign all of them.

Two of the most important documents in any real estate loan are the “loan document” and the “security instrument.”  The “loan document” evidences the loan, and is sometimes called an “Agreement”, a “Loan Agreement”, a  “Promissory Note” or something similar.  Borrowers might talk about receiving a “Mortgage” but in California most borrowers won’t be able to find a document called a “Mortgage” in their stack of loan papers.  That’s because Mortgages can be used, but common practice in California is to use something called a “Deed of Trust” instead of a Mortgage.  Such a “Deed of Trust” is a security instrument.  A “Deed of Trust” serves as “security” for a loan, which means that the lender can look to the “security” for payment if the borrower doesn’t repay the loan as agreed.   Most often the lender looks to the “security” for repayment through foreclosure.

Sometimes the relationship between the “Promissory Note” and the security instrument, or “Deed of Trust,” is not well understood.  Borrowers can mistakenly think that the “Deed of Trust” is the actual loan document.  But that is not the purpose nor the effect of a “Deed of Trust.”  In most cases, a Deed of Trust only serves as “security” for the loan in case the borrowed money is not repaid.

A Deed of Trust transfers a present interest in the property to the lender (the lender is typically the “beneficiary” under the Deed of Trust, which means that the lender is to receive the “benefit” of the Deed of Trust.)  When a loan is repaid, a Deed of Trust isn’t “canceled” or “terminated.”  Instead, the lender “reconveys” the property interest back to the borrower. In other words, the lender gives back to the borrower the property interest the lender received under the Deed of Trust.

Releases Can Be Complex

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            What happens if a lender returns, or reconveys, a Deed of Trust to a Borrower? Can a Borrower remain liable for an unpaid loan even if a Deed of Trust (or mortgage) is reconveyed to the Borrower?

Many years ago this question was addressed in a California court case.  In that case, two partners received a loan of $1,552 from a lender.  The two partners signed a Promissory Note.  The partners also signed a mortgage (which is similar to a Deed of Trust).  This mortgage provided the lender with a security interest in property that was owned by the partners.

The First Partner repaid $35 to the lender (and that was all that he paid).  The lender then released his mortgage on the Property so that the Property could be sold.  The Property was sold for $800, and this amount was paid to the lender.  The Second Partner thereafter paid off the remaining loan balance through a combination of payment and providing labor. (This means the Second Partner paid about $717 to the lender). The Second Partner then asked the Second Partner for reimbursement, because the First Partner had only paid $35, but the Second Partner had paid $717.

The First Partner refused to reimburse the Second Partner, in part because the mortgage had been released.  The First Partner claimed that the debt to the lender was fully discharged by the release of the mortgage, and that therefore the First Partner had no further liability on the loan.

The Court ruled that a release of a mortgage does not automatically discharge a loan.  (This means a borrower can get their mortgage released, but such a borrower may still owe money to a lender unless the lender also releases the borrower from liability on the loan).

This is an old case.  It might seem like $800 is a low price for a sale of property.  That’s because property prices were much lower when this case was decided.  The Promissory Note in this case was signed by the two partners shortly after gold was discovered in California – the Promissory Note was signed in 1850, and the court’s opinion was published in 1854.  The case was decided by the California Supreme Court, and is reported as Sherwood v. Dunbar (1854) 6 Cal. 53.

The Sherwood case discusses a general principle of real estate law, but the correct application of this law to any given situation requires the kind of skills employed by an attorney. Issues regarding a release of borrower liability under a loan, a Promissory Note, a mortgage or a Deed of Trust are complex.  It would be easy for borrower to misunderstand the legal principles involved in such a release or when such a release is actually effective. Lending laws and Real Estate laws are complex.  Borrowers faced with questions or issues involving loans or real property security instruments should consult an attorney and a tax professional.