This article explains the private lender’s exemption from usury limitations when using a licensed real estate broker.
Use a broker and avoid usury limitations
When a loan is made, the lender charges the borrower “interest” for use of the money during the period lent. However, the amount of interest a private, non-exempt lender can charge is regulated by statute and the California Constitution, called usury laws. [Calif. Constitution, Article XV; Calif. Civil Code §§1916-1 through 1916-5]
Today, the remaining goal of usury laws is the prevention of loan-sharking by private lenders – charging interest at a higher rate than the rate established by the usury laws. [CC §1916-3(b)]
Adopted in 1918 as a consumer protection referendum, the first California usury laws set the maximum interest rate at 12% for all lenders, no exceptions.
During the Depression, legislators noted the adverse effect the even-handed restriction on interest rates was having on the money supply and the economy.
So, in 1934, usury laws were constitutionally amended – lowering the maximum rate to 10% while exempting several classes of significant lenders entirely.
Lenders such as savings and loan associations (S&Ls), state and national banks, industrial loan companies, credit unions, pawnbrokers, agricultural cooperatives and personal property brokers could lend at whatever rate the market would bear without fear of penalty by forfeiture of interest.
Exemptions were successful in increasing the availability of funds and lowering interest rates due to competition.
When money again grew tight in the late 1970s, legislators applied the same strategy to loosen up funds held by individuals in savings accounts, initiating a proposition in 1979.
On passage of the 1979 initiative, real estate loans made or arranged by a real estate broker were added to the list of usury-exempt lender situations. [Calif. Const. Art. XV]
The 1979 law also gave the legislature the power to exempt other classes of lenders from usury limits.
The legislature has since exempted corporate insurance companies and consumer finance lenders.
When a borrower pays interest on a loan he is really paying “rent” to the lender for the right to use the lender’s money for a period of time. The money lent is fully repaid during or at the end of the period.
Normally, the amount of interest charged is a fixed or adjustable percentage of the amount of money loaned.
Though interest is commonly paid with money, interest may also be paid with property or services. The many types of consideration given for making a loan become part of the lender’s yield on the loan. [CC §1916-2]
Thus, interest includes all compensation a lender receives for lending money, whatever its form, excluding reimbursement or payment for loan origination services rendered. [CC §1915]
However, it is common for non-exempt private lenders to attempt to evade the usury law restrictions on interest (and taxes) by including “bonus” charges or claiming commission fees for their making the loan.
Any lender can charge the borrower a bonus, commission or discount, or receive services or goods from the borrower. However, charges and receipts are considered interest when they do not compensate or reimburse the lender for services rendered in the origination of the loan.
Charges unrelated to loan origination services are added to the interest stated in the note to determine the aggregate yield on the principal. The average annual yield over the life of the loan may not exceed the interest rate ceiling of usury laws – unless the loan transaction is exempt. [Haines v. Commercial Mortgage Co. (1927) 200 C 609]
A lender may charge the borrower for performing “services” or expenses incurred to originate the loan, without having to include these charges in the interest yield.
As long as the service performed or the expense incurred was necessary to the origination of the loan, the charges do not add to the lender’s yield and is not interest. [Klett v. Security Acceptance Co. (1952) 38 C2d 770]
Examples of “non-interest” services and expenses include:
- appraisal, escrow and recording fees [Ex Parte Fuller (1940) 15 C2d 425];
- negotiation and brokerage fees paid to a third party [Ex Parte Fuller, supra];
- administrative costs – such as foreclosing on the defaulted loan or reconveyancing [Penziner v. West American Finance Company (1937) 10 C2d 160];
- attorney fees for legal services relating to the loan – such as preparation or review of loan documents [Murphy v. Wilson (1957) 153 CA2d 132]; and
- late charges due on loan default or prepayment penalties. [First American Title Insurance & Trust Co. v. Cook (1970) 12 CA3d 592]
Setting the interest rate
If the proceeds of a loan, including home equity loans, funded by a non-exempt lender are earmarked primarily for personal, family, or household use by the borrower, then the maximum annual interest rate is 10% per annum, whether secured or unsecured. [Calif. Const. Art. XV §1(1)]
However, loans made for the improvement, construction, or purchase of real estate are subject to a different maximum annual rate of interest over the life of the loan, which is the greater of:
- 10% per annum; or
- the applicable discount rate of the Federal Reserve Bank of San Francisco (FRBSF), plus 5%.
Determining the discount rate
The discount rate of the Federal Reserve Bank of San Francisco (FRBSF) is the rate charged to member banks on advances.
The discount rate is reviewed no less than once every fourteen days by the Board of Directors of the Federal Reserve Bank of San Francisco. A review can bring a change in the discount rate – depending on how the directors view the economic health of the region, nation and world.
To determine the maximum interest rate allowable under usury limitations, the applicable federal rate (AFR) is set for each month. The rate set for a particular month applies to transactions entered into anytime during that month.
The federal reserve discount rate applicable to loans agreed to or funded during a particular month is the San Francisco Federal Bank rate on the 25th day of the previous month.
A loan transaction falls within a particular month based on the date the earlier of:
For example, a private lender signs loan escrow instructions on April 22, agreeing to fund the loan in two weeks, in the month of May. No prior loan agreements exists.
The Federal Reserve discount rate is 7% for April, the month in which the loan escrow instructions (or other loan agreement) were signed – entered into – by all parties.
The interest rate agreed to is 12% – the maximum yield permitted for the month of April (7% plus 5%).
However, on April 25th, the discount rate falls from 7% to 6%. Thus, the FRBSF rate for the month of May is 6%.
Prior to closing in May, the borrower claims his loan interest rate should fall to 11% to reflect the change, because 12% is usurious for the month of funding.
However, 7% was the discount rate in effect on the 25th day of the month preceding the month of April during which the lender committed – by signing the loan escrow instructions or other agreement – to make the loan.
Since the commitment to make the loan occurred earlier than the funding, the rate for the month in which the commitment occurred controls – even though the loan was funded in a following month controlled by a different (and lower) rate.
Editor’s note — Contingent interest, such as increased interest received on an adjustable rate loan (ARM), is not subject to usury limitations, unless the ARM contained a note rate in excess of usury limitations when originated, or the ARM was designed with an intent to evade usury laws. [McConnell v. Merrill Lynch, Pierce, Fenner & Smith, Inc. (1978) 21 C3d 365]
Usury law and real estate loans
Two basic classifications of private loan transactions exist relating to interest rates private lenders may charge on real estate loans:
- “brokered” real estate loans; and
- “restricted” or unbrokered real estate loans.
“Brokered” real estate loans are exempt from usury restrictions. Brokered real estate loans fall into two categories:
- Loans made by a licensed real estate broker as the private lender funding the loan.
- Loans arranged for private lenders by a licensed real estate broker as an agent for compensation.
“Restricted” real estate loans are all loans made by private party lenders which are neither made nor arranged by a broker.
Editor’s note — Private parties include corporations, limited liability companies and partnerships. These entities would not be exempt from usury limitations unless operating under an exempt classification, such as a personal property broker or real estate broker.
The most common “restricted” loan involves private party lenders, unlicensed and unassisted by brokers, who make secured or unsecured loans.
For example, a borrower contacts an individual lender for a loan of money. The lender is a licensed California real estate broker. The lender loans the funds and the borrower executes a note in favor of the lender, secured by a trust deed on real estate owned by the borrower.
The rate of interest called for in the note is in excess of usury limitations.
The borrower timely repays the note and the lender reconveys the trust deed. The borrower then demands the lender return all interest paid, claiming the loan was a usurious transaction. The lender rejects the interest refund demand, claiming he is a licensed real estate broker and loans arranged by him are exempt from usury laws.
Is the borrower entitled to a refund of the interest paid?
No! The loan was made by an individual who was a licensed California real estate broker when the loan was originated. Thus, the loan is exempt from usury limitations. [ Garcia v. Wetzel (1984) 159 CA3d 1093]
Although loans made or arranged by brokers are exempt from usury limitations, loans made by a private lender to a borrower who is a licensed real estate broker are not exempt.
Exceptions for private parties
Private party transactions involving the creation of a debt which avoid usury laws break down into two categories:
- Debts excluded, as not involving a loan.
- Debts exempt, involving loans or a forbearance on a loan.
The most familiar of the excluded “non-loans” is the seller carryback, called a purchase money debt.
Purchase money notes executed by the buyer in favor of the seller of any real estate, secured or unsecured by the property sold or other property, are not loans of money, but are credit sales.
As a credit sale debt, a seller can carryback a note, secured or unsecured, at an interest rate in excess of the usury limit, and the excess rate is enforceable since the debt is not a loan subject to usury laws.
Attorneys as brokers
Although attorneys are authorized to perform brokerage activities for compensation, an attorney’s activities in arranging a loan are not covered by the broker’s usury exemption.
For example, a borrower retains an attorney, who is also a licensed real estate broker, to arrange a loan from a nonexempt private lender to be secured by real estate owned by the borrower.
Between the time the attorney/broker is retained by the borrower and the time the loan is arranged, the broker’s license held by the attorney expires. The loan transaction is closed before the attorney renews his broker’s license. The note is payable in monthly installments of interest only, principal being payable as a final/balloon payment on the due date.
After making several interest payments, the borrower defaults and the lender begins foreclosure.
The borrower claims the loan has a usurious rate of interest since the attorney arranging the loan did not have a valid broker’s license when the lender committed to make the loan. The lender claims the loan is exempt fro usury laws since the attorney is authorized to conduct, for compensation, all activities requiring a broker’s license without first obtaining a broker’s license.
Can the borrower avoid all interest payments on the attorney-negotiated loan?
Yes! While attorneys may perform acts requiring a broker’s license, attorneys arranging loans without being licensed as brokers do not bring the loan under the broker’s exemption to usury laws. Thus, the loan is usurious since the attorney’s brokerage license was expired on the date the loan was agreed to, barring the private lender’s collection of interest from the borrower. [Del Mar v. Caspe (1990) 222 CA3d 1316]
Penalties for usury
The most common penalty suffered by a lender for usury is the nullifying of all interest for the loan. Thus, the lender is only entitled to a return of the principal advanced on the loan. [Bayne v. Jolley (1964) 227 CA2d 630]
The lender may also have to pay a usury penalty of treble damages. [CC §1916-3]
Treble damages are computed at three times the total interest paid by the borrower during the one year period preceding his filing a suit, plus the period until the time of judgment.
An award of treble damages as a penalty is normally reserved for a lender the court believes took grossly unfair advantage of an unwary borrower. [White v. Seitzman (1964) 230 CA2d 756]
A borrower who, at all times, knew a loan interest rate was usurious is not likely to be awarded treble damages. Also, a lender who sets a usurious rate in complete ignorance of the illegality of usury would not be additionally penalized with treble damages.
Usurious loans to broker/borrower
Consider an owner of real estate who is a licensed real estate broker and negotiates directly with a private lender to obtain a loan secured by his property.
The interest charged for the loan is at an annual rate in excess of the usury limitation.
The loan is negotiated without the services of another real estate broker.
The lender funds the loan escrow. The trust deed is recorded, and the lender is delivered the note while the borrower is handed the net loan proceeds on closing.
When the note comes due the owner/broker tenders payment of an amount equal only to the principal advanced by the lender, and demands a reconveyance. The owner claims he owes no interest, only the principal borrowed, since the interest rate is usurious.
The private lender claims the loan transaction is exempt from the interest restrictions of California’s usury laws since the borrower is a licensed real estate broker.
Is this loan controlled by usury laws – even though the owner who borrowed the money is licensed as a real estate broker?
Yes! The private lender’s rate of return on the loan is limited by usury laws, unless the private lender is a licensed real estate broker or a real estate broker is paid to negotiate the loan as an asset of one of the parties. [Winnett v. Roberts (1986) 179 CA3d 909]
Now consider a broker who is also a general partner in a partnership. The partnership wants to borrow money to improve real estate it owns.
The broker/general partner negotiates with a private non-exempt lender for a loan which is to be secured by real estate owned by the partnership.
The lender funds the loan. The lender receives the partnership’s promissory note and trust deed executed in favor of the lender by the general partner on behalf of the partnership. The rate of interest called for in the promissory note is in excess of usury limitations.
The partnership timely repays the loan and the lender reconveys the trust deed. The partnership then demands the lender return all interest paid on the loan, claiming the loan was usurious.
Is the partnership entitled to a refund of interest paid on the loan?
Yes! The partner is not acting in the capacity of a licensed broker when he negotiates a loan on behalf of the partnership, he is acting as its general partner. [Green v. Future Two (1986) 179 CA3d 738]
Editor’s note — Another California appeals court has held in a nearly identical factual situation – tenants in common acting as a group – that the broker acting on behalf of a partnership of which he is a member is considered to be acting for others and thus operating in his licensed capacity. [Stickel v. Harris (1987) 196 CA3d 575]
However, the court in Stickel did not have a firm grasp on brokerage law. The analysis in the case is faulty as its conclusion relies on the erroneous assumption a broker’s license is required for a general partner to deal with real estate owned by the partnership.
No fee was received for or was contingent on the act of negotiating the loan. The general partner received only the benefits he would have received as a partner whether or not this loan was originated.
Salesmen and usury
Activities of licensed salesmen are not within the broker’s usury exemption, unless the salesman is working for a broker whose level of participation in the transaction constitutes arranging the loan.
For example, an owner wants to refinance a loan secured by real estate he owns. The owner contacts a broker, and the broker and owner discuss acceptable terms for the loan.
However, the broker is unable to find a lender to fund the loan. The broker then informs an affiliate with whom he shares office space, a salesman who is not employed by a broker, about the loan. The salesman finds a lender who funds the loan. The interest rate called for in the note exceeds the rate allowable under usury laws.
The salesman is paid a fee directly by the borrower. The salesman does not split his fee with the broker, but does use some of his income to pay joint office expenses.
The owner makes all payments due on the loan and the lender reconveys. The owner then demands a refund of all interest paid, claiming the loan was usurious since it was arranged by a salesman, not a broker.
Is the owner entitled to a refund of the interest?
No! The broker’s initial setting of the terms for the loan with the borrower is enough involvement in the transaction for the loan to be considered arranged by a broker. Although the broker did not receive direct compensation, he did receive indirect compensation for his involvement since the salesman contributed to common office expenses. Thus, the loan is exempt from usury limitations. [Jones v. Kallman (1988) 199 CA3d 131]
Now consider a salesman who arranges loans for a non-exempt private lender as an agent of a broker. The salesman terminates his affiliation with the broker, but does not inform the lender.
Later, a borrower contacts the salesman seeking a loan to be secured by real estate owned by the borrower. The salesman arranges the loan which is funded by the private lender. The borrower executes a note and trust deed in favor of the lender. The interest called for in the note is in excess of usury limitations. The borrower pays the salesman a fee.
After making several interest-only payments, the borrower defaults and the lender begins to foreclose.
The borrower claims he does not owe any interest to the lender, and all interest paid should be credited to principal, as the loan was not arranged by a licensed real estate broker, and is thus usurious.
Can the borrower avoid paying any interest on the loan since the real estate salesman was not working for a broker at any time while arranging the loan?
Yes! For a loan arranged by a salesman to be exempt from usury laws, the salesman must be working for a broker while arranging the loan. Since the salesman was not employed by or affiliated with a broker at any time during which the loan was being arranged, the loan is not exempt from usury laws. [Dierenfield v. Stabile (1988) 198 CA3d 126]