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Litigation Over the Calculation & Application of Mortgage Loan Payments, Late Fee Charges & Escrow Accounts

Expert Witness: Don Coker
Many disputes between borrowers and mortgage lenders have at their root the question of how mortgage payment amounts should be applied to the loan balance. Other lawsuits arise over questions involving escrow accounts and the payment of insurance premiums and property taxes.

Quite often, litigation is brought against lenders due to a lack of understanding on the part of borrowers as to what he or she is required to do or should do in particular circumstances, and what the lender is legally permitted to do in order to protect its interest in their loan collateral.

First of all, let’s look at the four critical sections of a standard Fannie Mae – Freddie Mac mortgage and one critical section from a standard Fannie Mae – Freddie Mac note form:

3. Application of Payments. Unless applicable law provides otherwise, all payments received by Lender under paragraphs 1 and 2 shall be applied: first, to any prepayment charges due under
the Note; second, to amounts payable under paragraph 2; third, to interest due; fourth, to principal due; and last, to any late charges due under the Note.

7. Protection of Lender’s Rights in the Property. If Borrower fails to perform the covenants and agreements contained in this Security Instrument, or there is a legal proceeding that may
significantly affect Lender’s rights in the property (such as a proceeding in bankruptcy, probate, for condemnation or forfeiture or to enforce laws or regulations), then Lender may do and pay for whatever is necessary to protect the value of the Property and Lender’s rights in the Property, Lender’s actions may include paying any sums secured by a lien which has priority over this
Security Instrument, appearing in court, paying reasonable attorneys’ fees and entering on the Property to make repairs. Although, Lender may take action under this paragraph 7, Lender
does not have to do so. Any amounts disbursed by Lender under this paragraph 7 shall become additional debt of Borrower secured by this Security Instrument. Unless Borrower and Lender agree to other terms of payment, these amounts shall bear interest from the date of disbursement at the Note rate and shall be payable, with interest, upon notice from Lender to Borrower requesting payment.

9. Inspection. Lender or its agent may make reasonable entries upon and inspections of the Property. Lender shall give Borrower notice at the time of or prior to an inspection specifying reasonable cause for the inspection.

27. Late Charge. Borrower shall pay to Lender a late charge of 5 percent of any monthly installment of principal and interest as provided in the Note not received within 15 days after such installment is due.

There is also one key section of from the standard Fannie Mae – Freddie Mac Note form that states:

7. Borrower's Failure to Pay as Required
(A) Late Charges for Overdue Payments
If the Note Holder has not received the full amount of any monthly payment by the end of 15 calendar days after the date it is due, I will pay a late charge to the Note Holder. The amount of the charge will be 5.000% of my overdue payment of principal and interest. I will pay this late
charge promptly but only once on each late payment.

Escrow Account Balances

Mortgage lenders are permitted to require that borrowers establish and maintain escrow accounts in order to insure the payment of taxes and insurance on the mortgaged property. The creation and administration of escrow accounts are governed by the note and mortgage, and by the Real Estate Settlement Procedures Act (“RESPA”).

The standard Fannie Mae – Freddie Mac mortgage form states: “Lender may, at any time, collect and hold Funds in an amount not to exceed the maximum amount a lender for a federally related mortgage loan may require for Borrower’s escrow account under the federal Real Estate Settlement Procedures Act of 1974 as amended from time to time, 12 U.S.C. Section 2601 et seq. (“RESPA”), unless another law that applies to the Funds sets a lesser amount.”

RESPA defines an escrow account as “…any account that a servicer established or controls on behalf of a borrower to pay taxes, insurance premiums (including flood insurance), or other charges…” 24 C.F.R. § 3500.17(b).

Sometimes, lenders choose not to require a borrower to establish and maintain an escrow
account. Some circumstances that may cause a lender to not require an escrow account are when the borrower has demonstrated the financial capacity and willingness to make the tax and insurance payments on their own, or where the property has a property tax exemption.

If a lender has permitted a borrower to pay their taxes and insurance on their own, and the lender receives notice that the borrower has not paid their insurance or their taxes, then the lender has the right to establish an escrow account and require that the borrower not only pay the taxes and insurance amounts that are owed but also require the borrower to begin making monthly payments into the escrow account so that there will be sufficient funds on hand in the account to pay the renewal insurance premium and the next year’s tax bill when they are due.

If a borrower fails to maintain insurance coverage on their property that serves as collateral for their mortgage, then the lender is permitted to obtain coverage and add the expense to the borrower’s loan balance.

The property insurance that a lender purchases for a collateral property generally is more expensive than what the homeowner would pay since the lender essentially is buying the equivalent of fire and extended coverage and a homeowner can obtain a more reasonably priced homeowner’s policy.

Generally, what happens is that the lender adds the property to their blanket policy that all lenders have in place to cover these situations. It is standard for the insurer not to issue any document intended to go to the homeowner since the homeowner does not have any interest in the coverage on the property. Lenders vary on their practices in how they notify borrowers after insurance coverage is obtained, but it has been my experience that virtually all lenders do not send any evidence of insurance coverage to the homeowner since the homeowner does not have any interest in the coverage obtained by the lender.

Also, it is very important to note that the insurance coverage a lender purchases only covers the lender’s interest in the property; so the borrower is exposed to any value loss that exceeds their loan balance as well as any insurance coverage for the contents of the house, which are usually estimated at about 40% of the value of the property.

Likewise, if a borrower fails to pay their property taxes covering the collateral property, the property is subject to having a lien filed against it by the taxing authority (or authorities); so the lender is permitted to pay the property taxes and add the expense to the borrower’s loan balance.

Both of these actions are considered nationwide banking, mortgage banking, mortgage lending, and mortgage loan servicing industry standard practices and appropriate for a lender to take since they add needed protection to the lender’s collateral.

Furthermore, it is a common practice in the mortgage banking industry for mortgage loans to be sold in the secondary market, resulting in a situation where a mortgage loan is serviced by one financial institution but is actually owned by another financial institution. In this case, there is always some document – typically called a sales and servicing agreement, or something similar – that serves as an agreement between the owner of the loans and the servicer of the loans as to how the servicing financial institution must service the loans. In every one of these agreements that I have seen in over forty years in the banking, lending, and mortgage banking businesses, the servicing financial institution is contractually obligated to make sure that the collateral property is covered adequately by insurance and that the property taxes are paid so that no property tax liens are filed against the collateral property.

In some unusual cases, it may occur that a lender may hold in a suspense account some funds paid in by a borrower and intended to be used at some point in time for the payment of principal and interest. In these cases, it is important to note that RESPA rules as well as most loan agreements prevent a lender from using any funds that the lender may be holding in a suspense account and that were intended to be applied to principal and interest payments to pay for insurance and real estate taxes.

Nothing in RESPA or in Regulation X requires that a lender deduct funds held in a suspense account intended for principal and interest payments before calculating monthly escrow amounts.

How Late Fees Are Assessed

According to standard loan documents, such as the Fannie Mae – Freddie Mac mortgage and note documents cited elsewhere in this article, a borrower agrees to pay a late fee each time that they fail to submit a monthly payment on or before the due date of the payment and after any grace period that may be contained in the loan documents.

The two purposes of late fees are (1) to provide the borrower with an incentive for timely payments, and (2) to allow the lender to recover increased collection costs. The importance of providing such an incentive, through late fees, is necessary due to the significantly greater expenses associated with the collection of delinquent payments, such as the sending of late notices, delinquency letters, telephone calls, personal contacts possibly including personal visits, and the associated labor expenses. In order to achieve their purpose, late fees not only be must assessed, but also must be paid and collected.

It is a nationwide industry standard practice in the banking, mortgage banking, mortgage lending, and mortgage loan servicing industries for a lender to apply funds received first to the debt that becomes due first. Therefore, when a borrower skips a monthly payment, the next payment received is the late payment and should also include a late charge.

If the borrower skips a monthly payment and the next month just pays the regular monthly payment amount due, then they have failed to pay the late charge for the previous payment that is now being paid late. The principle is that the funds received should be applied to the monthly payment that became due first, i.e., the skipped month.

For example, if a borrower misses a monthly payment in January but makes timely payments in the amount of the regular monthly payment in February, March, and April, then the borrower has missed four payments, not just one. The reason is that the amounts the borrower paid in February, March, and April were not timely payments of the payment due in each of those months, but rather in each case they were payments for the installment due in the immediately preceding month. Each payment should be applied to the monthly payment first due, so in the example just cited, each payment would be considered late.

A key point to recognize is that the missed payment never was made up. Had the borrower made a double payment and included one late charge, then they would have caught up the payments and avoided further late charges.

This subject is covered by a Federal Trade Commission staff opinion letter issued in the implementation of Regulation AA (12 C.F.R. § 227.15, the Federal Reserve Board’s implementing regulation of the Federal Trade Commission’s Credit Practices Rule. This FTC staff opinion letter addresses a prohibition against the so-called “pyramiding” of late charges, and explains that a creditor “cannot charge for a late payment more than once…regardless of how many months late the payment was,” . . . The prohibition in the Rule addresses the situation where a “payment is otherwise a full payment for the applicable period and is paid (on time) where the only delinquency is attributable to late fee(s) . . . assessed on earlier installments”.

In other words, if the borrower’s payment brings his or her account current except for a previous late charge on a payment that was late, then no additional late charge may be imposed. However, if the consumer’s account remains delinquent because of a delinquency attributable to something more than a late fee, such as completely missing a monthly payment, then a new late fee can be assessed. In this situation, the assessment of additional late fees clearly is not prohibited because the loan’s delinquency is caused by more than the nonpayment of the original late fee.

It is a nationwide industry standard practice in the banking, mortgage banking, mortgage lending, and mortgage loan servicing industries that late fees are applied as described in the preceding paragraphs.

Notice of Late Fees at the Time They Are Assessed

Sometimes, borrowers complain after the fact that they were not notified of late fees at the time that the late fees were assessed. However, standard note and mortgage forms simply do not require a lender or loan servicer to provide any notice to the borrower before late fees may be assessed. Notice is contained in the note and mortgage signed by the borrower.

It is a nationwide industry standard practice in the banking, mortgage banking, mortgage lending, and mortgage loan servicing industries that a mortgage lender or mortgage servicer is not required to provide notice to a borrower before imposing a late charge for a late payment.


Disputes over the payment terms and escrow terms of mortgage loans can usually be resolved simply by a close and reflective reading of the loan documents.

Fannie Mae and Freddie Mac mortgage and note forms are very similar from state to state, facilitating these analyses.

The industry standard practices and procedures in these areas have been the same for many years.

ABOUT THE AUTHOR: Banking and Mortgage Banking Consultant and Expert Witness Don Coker
Over 460 cases for plaintiffs and defendants nationwide, 110 testimonies, and 12 courthouse settlements in all areas of banking and finance. Listed in the databases of recommended expert witness consultants of both the DRI and the AAJ. Clients have included numerous individuals, 60 banks, and governmental clients such as the IRS, FDIC.

Employment experience includes Citicorp, Ford Credit, and entities that are now JPMorgan Chase Bank, BofA, Regions Financial, Guaranty Bank, and a two-year stint as a high-level governmental financial institution regulator. BA from the University of Alabama. Postgraduate and executive education work at Alabama, University of Houston, SMU, Spring Hill College, and Harvard Business School.

Clients in 28 countries for work involving 57 countries. Widely published, often called on by the media.

Copyright Don Coker

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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