Supreme Court of Texas Holds Modified Home Equity Loans Not Subject to “80% Rule”

By:   Joshua A. Huber

In 1997, Texas became the last state in the nation to permit home equity loans. Because of Texas’ strong, historic protection of the homestead, home equity loans are regulated, not by statute as one might suppose, but by the “elaborate, detailed provisions” of Article XVI, Section 50 of the Texas Constitution.[1]  As previously noted in this blog, the Texas Constitution “prescribe[s] a Draconian consequence of noncompliance, whether intentional or inadvertent: not merely the loss of the right of forced sale of the homestead, but forfeiture of all principal and interest.”[2]  One of the detailed provisions, colloquially known as the “80% Rule,” provides that a loan-to-value ratio cannot exceed 80%.[3]

In Sims v. Carrington Mortg. Servs., LLC, 57 Tex. Sup. J. 588, 2014 Tex. LEXIS 396 (Tex. 2014), the Supreme Court of Texas addressed the following question certified by the Fifth Circuit:  “After an initial extension of credit, if a home equity lender enters into a new agreement with the borrower that capitalizes past-due interest, fees, property taxes, or insurance premiums into the principal of the loan but neither satisfies nor replaces the original note, is the transaction a modification or a refinance for purposes of Section 50 of Article XVI of the Texas Constitution?”[4]

The Sims obtained a home equity loan from Carrington Mortgage in 2003 and there was no dispute that the loan, when originated, satisfied the requirements of § 50(a)(6). After falling behind on their payments the Sims were given a loan modification in 2009, and again in 2011.[5]  Each time, past-due payments, interest and other charges, including fees and unpaid property taxes and insurance premiums, were capitalized into the modified loan, resulting in a higher principal balance. The Sims, personifying the maxim “no good deed goes unpunished,” commenced a class action against Carrington four months after the 2011 modification. The Sims alleged, among other things, that the modified balance of their home equity loan exceeded 80% of the value of their property, and that the loan was therefore void pursuant to the Texas Constitution’s 80% Rule.

The Sims argued that the modification was, in fact, a refinance or new extension of credit because the lender advanced new funds to cover past due amounts. Carrington contended that the modification did not satisfy or replace the original loan, and that the amounts capitalized were all part of and due under the terms of the original loan agreement.  In siding with Carrington, the Court stated “[t]he test should be whether the secured obligations are those incurred under the terms of the original loan.”[6] Based on this test and the clear language of the Sims’ loan modification agreements, the Court answered the certified question as follows:

“To the first certified question, we answer: the restructuring of a home equity loan that . . . involves capitalization of past-due amounts owed under the terms of the initial loan and a lowering of the interest rate and the amount of installment payments, but does not involve the satisfaction or replacement of the original note, an advancement of new funds, or an increase in the obligations created by the original note, is not a new extension of credit that must meet the requirements of Section 50.”

The Court’s decision is a win for both borrowers and lenders. As noted in the opinion, the approach advanced by the Sims would encourage lenders to foreclose rather than seek alternatives to keep borrowers in their homes. That potential became a reality as many servicers in Texas halted or reduced home equity loan modifications during the pendency of this case. Now that the uncertainty has been lifted, borrowers will likely be afforded more modification options, and lenders can proceed with modifications without fear of invalidating their loans.

[1]     Fin. Comm’n of Tex. v. Norwood, 418 S.W.3d 566, 571 (Tex. 2013); LaSalle Bank Nat’l Ass’n v. White, 246 S.W.3d 616, 618 (Tex. 2007) (per curiam).

[2]     Norwood, 418 S.W.3d at 571.

[3]     Tex. Const art. XVI, §50(a)(6)(B).

[4]     Sims v. Carrington Mortg. Servs., LLC, 538 Fed. Appx. 537, 547 (5th Cir. 2013).

[5]     Id. at *2-3.

[6]     Id. at *17.

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