Usury is law, ancient law, which basically says it’s wrong to charge too much interest. Despite its age, it’s a foggy mystery to many otherwise smart people, and it sometimes catches them off guard.
Like an old sea mine bobbing just out of sight, usury hovers near almost every consumer loan and promissory note transaction, ready to blow a deal out of the water. Attorney John J. Merchant explains how it can reach note buyers and brokers, using Washington State law as the example.
What usury means
The word has meant different things over time:
- Merriam-Webster: (1) archaic: interest; (2) the lending of money with an interest charge for its use, especially at exorbitant rates; (3) an unconscionable or exorbitant rate or amount of interest, specifically interest in excess of a legal rate charged to a borrower for the use of money.
- Easton’s Bible Dictionary: the sum paid for the use of money, hence interest; not, as in the modern sense, exorbitant interest. The Israelites were forbidden to exact usury from one another (Leviticus 25:36–37; Deuteronomy 23:19–20), and breaking that law was seen as a great crime (Psalm 15:5; Proverbs 28:8; Jeremiah 15:10).
- Gilbert Law Dictionary: the lending of funds at an exorbitant rate or at a rate above that permitted by law.
For a note buyer, the third meaning is the one that counts: interest above the rate the law allows.
Why usury is not a dead issue
The usury defense can be raised at any time after a loan is made, until the statute of limitations runs out. It can stop a lender or note holder from collecting the debt or, worse, expose the lender to liability and damages that may exceed the loan or note itself.
“Oh, come on,” you may say. “Usury went out with the dinosaurs. A lender can charge whatever interest he wants, and it’s nobody’s business but the borrower’s and the lender’s.”
Really? As recently as 2000, according to the Commercial Law League of America, nearly all states had statutory usury laws covering consumer loans. Only a couple of states had a legal rate on consumer (non-commercial) loans above 12%, not counting interest added by law to court judgments and statutory exceptions such as very small loans and credit cards.
A short lesson can’t list the legal rate in every state (that would probably run past 1,000 pages). Treat this as a yellow caution light: learn the legal interest and usury rates in your state, or the state of the transaction, before they affect a deal.
Washington State shows how sharp the teeth can be. In most private loans made there (with exceptions such as credit cards and small loans), interest above the state cap, which was 12% or a set number of points over a federal rate determined monthly by the state, is not only uncollectable. It is also usury under the state’s consumer protection statute. The borrower can collect actual damages plus punitive damages of 3 times actual damages, up to $10,000, plus attorney’s fees and court costs (at the time of writing).
None of this means interest is bad. Interest, money paid for the use of money, is a reality of life and an important tool that puts money where commerce and property need it. Without it there would be little reason to lend, and the world’s wealth would not exist as we know it.
Exemptions: commercial loans and first-lien home loans
Generally speaking, usury won’t apply to a commercial loan. But if a loan to an individual is really a consumer loan deliberately disguised as a commercial one, the courts may set the deal aside. Several Washington cases deal with exactly that: the courts found the deals were really individual consumer loans, subject to the usury laws, and ruled against the lender.
By statute, Washington says usury does not apply to transactions primarily for agricultural, commercial, investment or business purposes (RCW 19.52.080). It also excludes retail installment transactions (RCW 19.52.100).
If your state has a similar exemption and a lender wants to charge a questionably high rate, have an attorney make sure the loan is written to fit that definition. One approach is lending to a legitimate corporation, trust, registered partnership or other registered entity while requiring individual signatures from all the borrowing officers or partners.
First-lien residential loans
Federal law has largely removed first-lien residential loans from state usury coverage (see Brown v. Investors Mortgage Co., 121 F.3d 472 (9th Cir. 1997)). If you’re dealing with a first lien on residential property, usury probably doesn’t apply.
The Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA) preempts state usury laws for loans secured by a first lien on residential real property, while giving each state the option to override that exemption.
The author reviewed the citations in the U.S. Code Annotated and could not find any state that had specifically and deliberately elected to override it. A state supreme court could still decide that some statute had that effect. As of his writing, no court had ruled that any state had opted out of the federal exemption.
Two common note transactions show how usury can turn a simple-looking deal into trouble: recourse sales and simultaneous closings.
How recourse can make a note sale a usurious loan
In a recourse deal, the note buyer requires the note seller to guarantee the payments. If the borrower doesn’t pay as scheduled, the seller will.
Picture an everyday transaction. A buyer purchases a home for $100,000, paying $75,000 down. The seller carries back the $25,000 balance in a 10-year note at 12% interest, with monthly payments of $225 including principal and interest. So far, a ho-hum deal.
The home seller later sells the note for cash. The note buyer sees that the homebuyer’s credit isn’t the best and agrees to buy only if the home seller “goes recourse” and guarantees the payments. If the homebuyer stops paying, the note holder will look to the home seller.
Unless the note buyer paid 100% of face for that note, which normally just doesn’t happen, the note buyer and the note broker may have just committed usury, and the note buyer may now hold a usurious, uncollectable note.
“What? The home seller only charged 12%, the state’s legal maximum. How is that suddenly illegal?”
The usury here isn’t against the homebuyer. It’s against the note seller. “But the note seller sold his note. He didn’t borrow anything!” Under that state’s law, the court said it was a loan, not a sale.
Here’s how. The home seller charged the legal 12%, so he did nothing wrong. The note buyer bought at a discount to earn a yield well above 12%, which was his right. But by making the note seller guarantee the note, and then demanding that the seller pay the full remaining balance, the note buyer was trying to collect his whole anticipated yield (maybe 30% or more) from the note seller. The Washington Supreme Court called that usury.
“…where discounter [seller] of note makes himself liable as endorser, transaction is loan.” Finance & Insurance Agency v. Herron, 139 Wash. 499 (1926), Washington State Supreme Court.
Because that “loan” carried more than Washington’s 12% limit, it was usurious. And if a note broker had profited from the deal, the broker could have been named as another defendant, found liable for participating in usury and for violating the state’s Consumer Protection Act, and owed the note seller treble damages, court costs and attorney’s fees.
In short, a huge mess that would never have happened if the note buyer had not required the seller to sign as a recourse guarantor.
“That was 75 years ago,” you might say. “Ancient history.” Maybe. But in 1992 the Washington legislature put the same rule into statute, RCW 19.52.010:
“The discounting of commercial paper, where the borrower makes himself liable as maker, guarantor, or indorser, shall be considered as a loan for the purposes of this chapter.”
Remember, under Washington law, if it’s a loan, anything over 12% a year on a consumer loan is illegal usury. In Herron the homebuyer couldn’t have claimed usury, because to him the deal wasn’t usurious. The seller could.
Usury in simultaneous closings
Many note investors deal every day in simultaneous closings, where the property is sold, the buyer gives the seller a carryback note, and the note is sold at the same time to a note buyer at a discount. Usury can be a hidden minefield here too.
In Baske v. Russell, 67 Wn.2d 264, 407 P.2d 434 (1965), the Washington Supreme Court held that the note buyer, although completely unaware of it, was in fact and in law acting as a lender. He had made a usurious loan and was subject to the usury defense.
In that case, the discount was taken by the homebuyer (the borrower), not by the home seller as usually happens. The homebuyer signed a note for more than he actually received, and the interest he was effectively charged was far above 12%.
Whose state law applies
The author studied Washington law, not usury law in other states. Your state’s statutes and court decisions may contain similar rules, and not knowing them could be costly.
A party who feels wronged might sue in the state where the property is located, the lender’s state, the note buyer’s state, or the state where the deal was closed. So the usury laws of any or all of those states could bite the participants.
That multi-state hazard is one reason many institutional lenders have the borrower agree in writing that any lawsuit will be brought in a particular state, under that state’s laws, and that the borrower waives the right to sue elsewhere. These clauses don’t always hold up and are often challenged, so put the question to an attorney who knows the state’s law.
Protecting yourself as a note buyer or broker
In both cases above, hiring a lawyer to research the deal beforehand would have been money well spent.
The broader lesson: a note broker is generally safest selling to financial institutions that buy notes as a daily routine. Their people generally know enough to avoid these traps. Selling to anyone else can be very hazardous to your pocketbook.
Be especially careful when:
- The note buyer wants recourse.
- The borrower will sign for more money than he actually receives.
- For whatever reason, the deal looks and smells different.
In those situations, have someone competent check the law before you close.
