Mortgage Concepts is a recurring video series covering best practices and compliance education for California mortgage loan originators (MLOs). This video reviews mortgage terms and features prohibited in Section 32 loans. For course credit toward renewing your NMLS license, visit

Regulation Z (Reg Z) restricts or outright bans certain features in Section 32 loans commonly found in other types of transactions. Let’s review the restricted and prohibited features for Section 32 loans.

Balloon payments

These are payments more than twice as large as the average scheduled payments on the loan — and are prohibited in Section 32 loans. [12 CFR §1026.32(d)(1)(i)]

Section 32 balloon payments are only allowed in:

  • transactions with a payment schedule adjusted to the borrower’s seasonal or irregular income; [12 CFR §1026.32(d)(1)(ii)(A)]
  • short-term bridge loans of 12 months or fewer used to finance a new home purchase for a borrower selling their existing home; [12 CFR §1026.32(d)(1)(ii)(B)] and
  • balloon loans made by small lenders, provided the loan meets the ability-to-repay rules.  [12 CFR §1026.32(d)(1)(ii)(C); 12 CFR §1026.43(f)]

Related video:

Word-of-the-Week: Balloon payment

Negative amortization

This is the addition of unpaid interest to the principal balance of a mortgage due to insufficient monthly interest payments.

Section 32 loans may not include potential for this, except when the increased principal balance results from an increase in permissible charges unrelated to the payment schedule, such as property insurance. [12 CFR §1026.32(d)(2)]

Advance payments

Section 32 loans do not allow a payment schedule which consolidates more than two periodic payments, and pays them in advance from the proceeds. [12 CFR §1026.32(d)(3)]

Increased interest rate on default

Section 32 loans may not require an increased rate of interest in the event of a default, except for interest rate adjustments made on variable rate transactions. [Official Interpretation of 12 CFR §1026.32(d)(4)]


Calculation of rebates of interest on loan acceleration due to default which are less favorable than the actuarial method of calculation are prohibited. [12 CFR §1026.32(d)(5)]

Prepayment penalties

You might be wondering how this works with the prepayment penalty coverage test. It’s simple: the thresholds in the prepayment penalty coverage test are the new maximum limit. If a lender makes a loan allowing for a prepayment penalty extending beyond the 36-month limit, or for an amount greater than 2% of the prepaid amount, that loan is a Section 32 loan. The lender is then prohibited from charging any prepayment penalty on the loan. [12 CFR §1026.32(d)(6)]

Acceleration (due-on clause)

Acceleration or a due-on-demand clause is prohibited on Section 32 loans unless the borrower:

  • committed fraud or material misrepresentation in connection with the loan;
  • fails to repay the loan as agreed; or
  • adversely impacts the property securing the loan through their actions or negligence. [12 CFR §1026.32(d)(8)]

Subscribe to Quilix, firsttuesday’s agent- and broker-focused real estate newsletter, for news, market analysis and more compliance explainer videos.