In a September 29, 2009, letter to the Secretary of the U.S. Department of Housing and Urban Development (HUD), the Director of the Division of Consumer and Community Affairs of the Federal Reserve Board (FRB) stated that for loans that use the monthly interest accrual amortization method for allocating a payment to accrued interest and principal, the payment of interest after a loan is prepaid in full is not a prepayment penalty under Regulation Z. Under the monthly interest accrual amortization method, all loan payments are treated as having been made on the scheduled due date regardless of when made, provided the payment is made prior to the expiration of the payment grace period. Under this method if a payment is made early it is still treated as having been paid on the payment due date and the consumer does not receive any reduction in interest due. Likewise, if the payment is made after the due date, but during the payment grace period, the consumer is not charged any additional interest.

The FRB’s letter was in response to a HUD inquiry regarding the effect that the FRB’s July 2008 final rules amending Regulation Z would have on FHA loan prepayment policy. The July 2008 final rules, effective for applications received on or after October 1, 2009, define a class of higher-priced mortgage loans for which a prepayment penalty for longer than two years is prohibited and for some higher-priced loans prepayment penalties of any duration are prohibited. HUD inquired whether the prepayment penalty provisions of the July 2008 final rules would apply to certain FHA loans. More specifically, HUD inquired whether FHA loans are covered by Regulation Z staff commentary that provides that prepayment penalties include any “interest charges for any period after prepayment in full is made.” (See, comment 226.18(k)(1)-1.)

FHA loans use the monthly interest accrual amortization method when the loan is prepaid in full, and HUD advised the FRB that for FHA loans HUD does not consider the payment of interest after the prepayment date as a prepayment penalty. In its September 29, 2009, response letter to HUD, the FRB states that lenders that use the monthly interest accrual amortization method would not be required to treat the interest charged from the date of prepayment until the next installment due date as a prepayment penalty for any purpose under Regulation Z.

Please download attached file for complete Memorandum.