Legislative Background and Constitutional Language

When the Texas Legislature adopted the language for the constitutional amendment {H.J.R. No.

31}, and sent it to the voters for approval, the plain meaning of the language used by the legislature in H.J.R. 31 appeared to affect Texas homestead law in a very broad and sweeping manner.

There have been no Court of Appeals decisions construing this new constitutional language. In addition to the widely publicized home equity amendments, unknown to most Texas votes, the constitutional amendment also included language which added Sections 50(e) and 50(f), dealing with refinance transactions, to the Texas Constitution. The language of Sections 50(e) and 50(f) is very relevant to understanding what appears to be a “paradigm shift” in the constitutional validity of liens securing additional funds. The Constitution now provides:

"50(e)" A refinance of debt secured by a homestead and described by any subsection under Subsections (a)(1)-(a)(5) that includes the advance of additional funds may not be secured by a valid lien against the homestead unless:

(1) the refinance of the debt is an extension of credit described by Subsection (a)(6) of this section; or

(2) the advance of all the additional funds is for reasonable costs necessary to refinance such debt or for a purpose described by Subsection (a)(2), (a)(3), or (a)(5) of this section.

"50(f)" A refinance of debt secured by the homestead, any portion of which is an extension of credit described by Subsection (a)(6) of this section, may not be secured by a valid lien against the homestead unless the refinance of the debt is an extension of credit described by Subsection (a)(6) of this section.

The language clearly indicates that a lien securing "additional funds" is not a valid lien against homestead unless: (I) the refinance is a home equity loan (i.e. a Subsection (a)(6) loan); or, (ii) all the additional funds are for reasonable costs necessary to refinance.

The legislative history of Sections 50(e) and 50(f) indicates that the legislature did not intend to change the historical practice of including closing costs in a refinance transaction. However, the plain language of Section 50(e) does appear to change historical practice. Only if the language of Section 50(e) is determined to be ambiguous by the Texas Supreme Court will the legislative history become admissible evidence for determining the meaning of new Section 50(e).

4. Scope of Application

New Section 50(e) applies to any "refinance" loan transaction involving homestead property. This would include, but is not limited to, the following loan types: (i) refinance of purchase money loans;

(ii) refinance of ad valorem taxes; (iii) refinance of a federal tax lien; (iv) refinances of owelty liens;

(v) refinances of a mechanic lien contract/construction loan; and, (vi) refinances of existing home equity loans into new home equity loans. Section 50(e) does not appear to apply to new purchase money loans which are secured by a vendor’s lien and additionally secured by a deed of trust. If the land is non-homestead, the Section 50(e) would not apply.

5. Past Title Insurance Practices

On loans secured by insured deeds of trust involving homestead property, the title insurance industry has historically permitted the inclusion of loan costs and/or fees which would not technically be a valid lien against homestead property. Historically, these costs and fees have

been included in the amount of insurance on Schedule "A" of the mortgagee policy provided that the vast majority of funds secured by the insured lien secured debt which clearly constituted a valid lien against homestead property. The title insurance industry relied, in part, on favorable case law such as Miller et. al. v. Gibralter Savings and Building Association 132 S.W.2d 606; Freytag v.

American Federal Bank FSB 155 B.R. 150 {see also the unpublished decision of United States Court of Appeals for the 5^th Circuit 49 F3d 728}. Title companies also relied upon the "Partial Invalidity Clause" {see clause recited in (g)(2) below} which provided that invalid debt against the homestead would be deemed to be paid in the first few loan payments.

The addition of Section 50(e) and 50(f) to the Texas Constitution appears to significantly change Texas homestead law as it relates to refinance transactions. Now the constitution says {indirectly}

that unreasonable or unnecessary refinance costs will invalidate the entire deed of trust lien on a homestead. The constitution does not define what "refinance costs" are; nor does the constitution provide evidence of what "reasonable" means; and neither does the Constitution state what a “cost necessary to refinance” is.

Therefore, from an underwriting standpoint, the lender and title insurer need to determine the following three elements:

What is a refinance cost ? and

What is a reasonable refinance cost? and What is a cost necessary to refinance?

6. Reasonable Refinance Costs

Here is one “title attorney’s conservative paradigm” which may be used to determine what is a refinance cost:

Some underwriters have concluded, from an underwriting risk standpoint, that ONLY the following items are "refinance costs" which may be included in the amount of insurance for a mortgagee policy issued on a refinance loan secured by a deed of trust on homestead property:

a. Commercially reasonable Loan Origination Fee; and,

b. Commercially reasonable Loan Discount {Buydown} Points; and,

c. Commercially reasonable Mortgage Insurance Premium {i.e. FHA, VA or Conventional}; and, d. Up to 5% {five percent} of the loan amount to include the following "refinance cost" items:

application fee, appraisal fee, credit report fee, tax search fee, notary fee, courier fee, document preparation fee, funding fee, survey fee, recording fee, escrow fee, pest inspection fee, insurance premiums, and title insurance premiums. Also, pre-paid mortgage interest {and pre-paid insurance premiums} may be included in the five percent figure.

Note: Reserves Deposited With the New Lender

Some title insurers do not consider "reserves deposited with the new lender" as

a "refinance cost" because the borrower will receive {from the lender being paid off} a cash refund after closing if "escrow account reserve items" are included in the principal amount of the new refinance loan. This is very similar to a cash out loan and may present an unacceptable business risk under Sections 50(e) and 50(f). Therefore, some title companies will not include "reserves deposited with the new lender" {such as tax, insurance and annual assessment escrow impounds} in the new refinance loan amount.

Note: Payoff of the Existing Loan with the Old Lender

Sometimes, when the existing loan is paid off by the title company, the payoff arrives at the old lender’s office a few days before it was calculated to arrive. This results in an over payment of the old loan and a few days of "per diem" interest must be refunded to the borrower by the old lender after the loan is paid off. The view of most title insurers is that, provided that the title agent or direct operation has relied on the old lender’s written payoff statement, and provided that the closer has included a reasonable and typical amount of per diem interest so that the payoff will not arrive with insufficient funds to pay the old lender, most insurers will not treat the refund of a few days of per diem interest from the old lender to the borrower as creating an "additional funds" problem. The refund should come from the old lender and not from the title company.

Here is one method to determine if a fee is commercially reasonable:

a. For Loan Origination Fee:

Some insurers will recognize, for underwriting purposes, that origination fees are reasonable if the origination fee does not exceed {by more than 2.5%} the average origination fees reflected in the most recent "business section" of any one of the major Texas newspapers.

b. For Buy Down Points and Discount Points:

Some title insurance companies will recognize, for underwriting purposes, that buy down points/discount points are reasonable if the lender states, in writing, that the buy down points reflect a bonafide reduction in the loan interest rate from "market rate interest" to the "buy down interest" rate. The lender may state this in letter form or place a recital in the loan closing instructions.

c. For Mortgage Insurance Premium:

Some companies will recognize, for underwriting purposes, that mortgage insurance premiums are reasonable if the Texas Department of Insurance promulgated premium is paid by the borrower from loan proceeds.

d. For Other Refinance Costs:

Some insurers will recognize, for underwriting purposes, that the "other costs" shown under item (f)(4) above are reasonable if: (i) the Five percent cap is not exceeded; and, (ii) no fees other than those specified under item (f)(4) above are included.

7. General Underwriting Requirements

Under the guidelines of some title insurers, eligible Refinance Costs and Fees {as defined in Section f above} are subject to the following general underwriting requirements:

a. Lender Approval. The lender must approve the inclusion of the refinance costs, fees and points in the written loan instructions.

b. Partial Invalidity Clause. If not already pre-printed on the deed of trust form to be insured, the substantial equivalent of the following language {which has been approved by HUD} is suggested for the deed of trust:

"Partial Invalidity. In the event that any portion of the sums intended to be secured by this security instrument cannot lawfully be secured hereby, payments in reduction of such sums shall be applied first to those portions not secured hereby."

c. Subrogation Language. On refinance transactions, the new insured deed of trust should contain "renewal and extension" language which should be similar to the following:

"All or a portion of the proceeds of the note secured by this deed of trust represents funds advanced by Beneficiary to Grantor and that Grantor used in part to discharge a prior note in the original principal sum of

$ which is dated , executed by and payable to the order of . The prior note is secured by a deed of trust on the property from _________ to , Trustee, which is dated and recorded in Volume , Page of the Real Property Records of County, Texas {and if applicable, describe vendor's lien}. Grantor acknowledges that the lien(s) securing the prior note is valid, that it subsists against the property, and that by this instrument it is renewed and extended in full force until the note is paid {even if the prior lien is released and not assigned to the Beneficiary}."

d. Absolutely No Cash Back to Borrower. For title insurance purposes, the borrower(s) shall not leave closing with any loan proceeds {not even a penny}. If the closer is confronted with a situation where the lender wants the borrower to receive cash back in a typical refinance loan transaction {ie. the transaction is not a home equity loan or reverse mortgage loan}

some companies require that the closer obtain the lenders written approval to include the below exception.

"Invalidity of the insured mortgage by reason of the inclusion of additional funds prohibited under Article XVI, Section 50(e) and/or Section 50(f), of the Texas Constitution."

The former industry practice of allowing a principal reduction at closing (i.e. taking the "cash back" portion which would be paid to the borrower and applying it instead to reduce the principal of the loan at closing) may no longer be a good business risk. The only option available to avoid placing the above exception in the Mortgagee Policy {if the loan would result in "additional funds" or "cash back to the borrower"} is as follows:

(1) All loan documents are returned to the lender for re-drafting in order to reduce the loan amount so that the borrower does not receive any "cash back" or "additional funds".

e. Release or Assignment of Prior Lien. On refinance transactions, if a new lender is involved, it is a good business practice to obtain an "assignment of lien" for the old deed of trust/mechanic's lien contract being renewed. In cases where the old lender refuses to given an "assignment of lien" it is acceptable to nearly all title insurers to record a "release of lien"

for the old deed of trust/mechanic's lien contract being renewed.

8. Reminder Concerning Valid Loans on Homestead

The following is a general reminder of the loan types that are insurable on homestead property.

a. Refinance Transactions. On refinance transactions, the amount of insurance may also include the unpaid principal balance {and accrued interest} necessary to pay off:

(1) Vendor's Lien and/or Deed of Trust Lien(s) securing purchase money;

(2) Mechanic's Lien Contract for improvements;

(3) Ad Valorem Taxes against the homestead property;

(4) Federal Tax Liens;

(5) Owelty Lien; and/or,

(6) An existing deed of trust securing a valid renewal of item "i" and/or item "ii" and/or item

"iii" and/or item "iv" and/or item "v".

b. Purchase Money Loan Transactions. On purchase money loans where a vendor’s lien is reserved in the deed from the seller, and the buyer/borrower is simultaneously executing a Deed of Trust lien as additional security, most title companies indicate the amount of insurance may include the principal balance of the purchase money note which may include any loan costs which the lender advances. This may also include the "reserves deposited with the new lender." The constitutional restrictions concerning "reasonable closing costs"

and "no additional funds" do not appear to apply to purchase money loans.

c. Mechanic Lien Contract Loan Transactions. On mechanic lien contract transactions, where the mortgagee policy or binder will insure only the mechanic lien contract on Schedule

"A" {and not insure a deed of trust given in renewal and extension of the mechanic lien contract} most insurers agree that the amount of insurance may include the principal balance of the mechanic lien note which may include any loan costs which the lender advances. This may also include the "reserves deposited with the lender." The constitutional restrictions concerning "reasonable closing costs" and "no additional funds" do not appear to apply to purchase money loans.

9. Rate Rule Reminders

a. All Transactions. Under Rate Rule R-4, when requested by the lender, the mortgagee policy may be issued in an amount equal to the original principal amount of the loan not to exceed 25% of the loan principal amount. The lender is entitled to ask for this 125%

coverage regardless of whether refinance costs and fees have been included in the basic loan amount.

b. Refinance Transactions. On refinance transactions, the appropriate Rate Rule R-8 credit must be given regardless of which insurer issued the prior mortgagee policy. The fact that the prior mortgagee policy was issued for the simultaneous rate {or the fact that the prior mortgagee policy was issued for R-8 credit}, does not prevent the application of the R-8 credit to the refinance transaction. Please refer to Rate Rule R-8 for specific eligibility requirements. Premium credit under Rate Rule R-18 will generally not be given unless the new loan complies with Rate Rule R-18 and the prior mortgagee policy was issued upon the same title insurance company.

10. A More Liberal Underwriting Paradigm For Refinance Costs Includable in Mortgagee Policy Amount of Insurance

Some title companies have determined that they will rely upon the language in the legislative history that Section 50(e) was not intended to change existing practices or case law concerning the inclusion of refinance costs in the principal amount of the refinance loan.

Set forth in this section are refinance costs and fees which some underwriters have determined are includable in the mortgagee policy amount of insurance. These items include:

a. General Parameters:

The following items may be included without dollar or percentage limitations:

(1) The reserves for taxes, insurance and home owner association fees deposited with the new lender as escrow reserves.

(2) The mortgage insurance premium {FHA, VA or conventional}.

(3) Prepaid items {such as prepared insurance premiums and prepaid mortgage interest}

may be included.

b. Additional Items Which May Be Included Based Upon Percentage Limitations:

Set forth below is a table which outlines the criteria established for “Lender Controlled Charges” and “Third Party Fees” which are attributable to the refinance. The mortgagee policy may be issued without the special lien invalidity exception {see Section IV, Paragraph 1 below} if the fee structure is equal to {or less than} the following percentages:

Description Loan Amount Loan Amount

0 - 99,999.99 100,00.00 and over Lender Controlled Charges

For purposes of illustration, lender controlled charges include items such as: discount points, origination fee, buy down points, underwriting fee, processing fee, flood certification, inspection fee, tax service fee, loan delivery fee, administration fee, funding fee and loan submission fee.

3% 2%

Third Party Fees

Third party fees include such items as: appraisal, credit report, survey, attorney’s fees, messenger fees, title insurance premium, escrow fee, recording fees, messenger fees, tax certificates and copies.

4% 3%

11. No Cash Back to Borrower on Traditional Refinance Transactions a. Excess Cash at Closing:

Occasionally, the amount of the new loan slightly exceeds the amount of funds necessary

to pay off the old loans and pay all costs associated with the new refinance transaction. In this case, the borrower should not be permitted to obtain “cash back” at closing. There are two methods which the escrow officer may use in order to avoid the borrower obtaining “cash back” at closing. The methods for insuring without the lien invalidity exception are listed below:

(1) Redraft Loan Documents

The best procedure is for all loan documents to be returned to the lender for re-drafting in order to reduce the loan amount so that the borrower does not receive any "cash back" or additional funds.

(2) Principal Reduction At Closing

A secondary alternative is to simply take the amount which would be “cash to borrower at closing” and show it as a “principal reduction of the refinance loan” on the HUD-1 or HUD-1A statement. This will result in the borrower receiving “zero" cash at closing.

b. Borrower Wants Reimbursement for “Prepaid Refinance Costs”

Where lender/borrower are insistent on the borrower receiving a “refund of prepaid closing costs”, escrow officers may use the following procedure:

(1) Show the payment to the borrower on the Line(s) in the 1300 Section of the HUD-1 {or lines 1501 to 1515 of the HUD-1A} as a “refund of “ {describe “prepaid credit report”; or “prepaid application fee”; or “prepaid appraisal fee”...}

(2) The title company escrow check payable to the borrower should state {either on the front or back of the check}:

“Refund of “ {describe “prepaid credit report”; “prepaid application fee”;

or “prepaid appraisal fee”...}

(3) Line 303 of the HUD Settlement Statement {or line 1604 of the HUD 1-A} will then show no cash back to the borrower at closing.

12. Home Equity “Cash Out” Refinances

Note that “cash out/refinances”, where the borrower is actually obtaining a home equity loan {a portion of which is paying off a prior loan on the homestead}, are not subject to Section 50(e).

These loans must comply with Section 50(a)(6).

13. How the Section 50(e) Amendment May Affect Title Insurance Coverages a. Texas Department of Insurance Commissioner’s Bulletin B-008-98

The 3% Safe Harbor Archetype?

On April 24, 1998, the Texas Department of Insurance issued Commissioner’s Bulletin B-008-98, Title Bulletin No. 159, where the Department indicated that 3% might be a safe harbor for bona fide expenses connected with a refinance transaction. The Department was careful, however, to indicate that it lacks specific authority to define the constitutional terms.

The text of the bulletin is set forth below:

“The Texas Department of Insurance has received several recent inquiries about newly amended Sec. 50, Article XVI, Texas Constitution, as adopted by the Texas voters November 4, 1997.

Under Section 50(e) of the Constitutional Amendment:

A refinance of debt secured by a homestead and described by any

A refinance of debt secured by a homestead and described by any