Usury-avoidance provision in a mortgage is useless.

It is very common for mortgage documents to provide that if it is determined that the interest rate is usurious, that amount which exceeds the legal rate of interest will not be deemed interest, but will be considered to be a payment toward reducing the principal of the mortgage.

The Federal Home Loan Mortgage Corporation made a mortgage loan to a limited partnership which owned a building in Brooklyn. The loan went into default and the mortgage was foreclosed. After the foreclosure sale, Federal Home Loan Mortgage Corporation, as the lender, sought the excess money resulting from the foreclosure sale (the money from the highest bidder at the sale, less the costs involved, including referees' fees, etc.). The mortgagor however, claimed that the mortgage loan was usurious and was therefore void. If the mortgage loan was void, the mortgagor would be entitled to the excess money.

When the lender made the loan, it charged the mortgagor its legal fees as well as a 1 percent fee for "reasonable incidental expenses" in making the loan. The issue of whether the 1 percent fee made the loan usurious was referred to a Magistrate Judge to review the facts and recommend as to who would be entitled to the surplus money from the foreclosure sale.

If the 1 percent fee represented a charge for reasonable "incidental expenses," it would not render the loan usurious. The laws of New York provide that a borrower may pay all reasonable expenses incurred by a lender in making a loan without rendering the loan usurious. However, if the 1 percent fee was an "origination fee," or some other type of interest, the total interest rate would exceed the legal limit and the loan would be usurious.

The Magistrate concluded that the 1 percent fee was charged without regard to the lender's actual expenditures for incidental costs, and thus, the fee could be considered additional interest on the loan.

However, the Magistrate also concluded that the "usury-avoidance" provision in the mortgage note saved the loan from being usurious. The provision limited the amount of interest charged to the "legal rate" of interest. The provision also stated that in the event that any excess interest was paid, the lender would apply it to the principal balance. The Magistrate thus concluded that the "usury-avoiding" provision was valid and saved the loan from being usurious.

The recommendation of the Magistrate went to Judge Raymond Dearie, United states District Judge for the Eastern District of New York. Judge Deane accepted the conclusion of the Magistrate that the 1 percent fee was not for incidental costs incurred by the lender, but was a fee to be considered as additional interest. However, Judge Dearie did not accept the conclusion of the Magistrate that the usury-avoidance provision saved the mortgage loan from being usurious.

Judge Dearie cited the New York General Obligations Law [section]5-511, which states that usurious contracts are void. The statute distinguishes between loans made by banks and loans made by non-banks. The statute provides that loans made by lenders other than banks or savings and loan associations which are usurious, are void. When a court finds a contract usurious, the statute requires that it must declare the transaction void and order that all documents and collateral be canceled and surrendered. However, the statute also provides that when the lender is a bank or a savings and loan association, the usurious transaction is not void, but any interest thereon is forfeited. The Federal Home Loan Mortgage Corporation is not a bank nor is it a savings and loan association.

Judge Dearie then reviewed New York decisional law involving "usury-avoidance" clauses. He cited the opinion of the Appellate Division, First Department, that held that language proporting to reduce the interest rate to the legal rate in the event of a finding of usury does not make the agreement non-usurious. New York law is clear that when a non-bank loan is found to be usurious, the entire contract is void. Once a court concludes that a portion of a note violated the usury laws, the entire note must be held to be void.

Judge Dearie also cited various New York court decisions, including the Court of Appeals, which ruled that even if a lender repays the borrower the interest which is usurious, it does not save the loan from being usurious and therefore void. The courts have no power to order the borrower to repay the principal of a loan, even if the lender repays the usurious interest.

The Court of Appeals of New York reasoned that usury laws serve two purposes: (1) to void usurious transactions; and (2) to provide for forfeiture and penalties against the usurer. Therefore, the Court of Appeals ruled that a non-bank lender could not save a usurious contract by "tendering back" the excess interest. A usurious transaction is void ab-initio, and the return of excess interest cannot save for the lender the money the lender advanced or the interest due on the loan. The borrower under those circumstances is relieved from re-paying the principal balance due, and any interest.

Judge Deane ruled that the policy behind usury laws is clearly to protect unsuspecting vulnerable people, and therefore allowing a lender to avoid the usury laws by including a "usury-avoidance" provision undermines that policy. Otherwise, the lender will benefit from the usurious interest rate unless the contract is challenged, and then the lender would merely forfeit the excess interest. The statute clearly contemplates more, said the Judge. Judge Deane concluded that the "usury-avoidance" provision does not save the otherwise usurious loan, and since the loan is usurious, it is void. The lender in this case has no legal right to the excess money resulting from the foreclosure sale. The borrower, the mortgagor, is entitled to those funds.

Since the Federal Home Loan Mortgage Corporation is not a bank or a savings and loan association, its entire mortgage was lost. Had the lender been a bank, it would have been entitled to only that amount of surplus funds which would repay the principal amount of the loan, but would have forfeited all of the interest on the loan.

(Edward L. Schiff is a real estate partner in the Manhattan law firm of Hartman & Craven, LLP.)