Loan Servicing Agreements: Essential Features and Optimum Practices

What is a Loan Servicing Agreement?

A loan servicing agreement is a contract that outlines the responsibilities and expectations between a lender and a loan servicer regarding the management of a loan. It is a critical document in the lending process, as it establishes the terms by which a servicer will collect payments, manage borrower accounts, handle customer inquiries, and ensure compliance with applicable regulations. By clearly defining the roles and obligations of each party, a loan servicing agreement helps to streamline the process and provide clarity to both the lender and borrower throughout the life of the loan.
The loan servicing agreement typically includes key information such as the types of loans being serviced, the terms of the loan, payment schedules , interest rates, fees, default procedures, and the roles and responsibilities of both the lender and loan servicer. Additionally, it may outline the compensation structure for the loan servicer, reporting requirements, record-keeping obligations, and any indemnification provisions.
Loan servicing agreements are essential for both parties, as they help to establish a clear framework for how the loan will be managed. For lenders, the agreement serves as a safeguard, ensuring that the loan servicer will properly manage the loan and protect the lender’s interests. For loan servicers, the agreement provides them with the necessary authority to carry out their responsibilities in managing the loan on behalf of the lender.

Essential Elements of a Loan Servicing Agreement

Traditional loan servicing agreements typically delineate the rights and obligations of both the servicer and borrower, and deeper describe the expectations of the selected servicer regarding the management and collection of existing and future loans. These agreements often set forth the term of the agreement along with the schedule for measuring performance, expectations in the event of default, fees to be paid by the borrower, penalties for below-performance, required reporting and records retention requirements.
A loan servicer will frequently charge a servicing fee for its activities. This fee might be based on a flat fee arrangement or a percentage of the outstanding principal balance. Many servicers will impose additional fees for returned items such as for NSF checks, annual late fees and property preservation charges for maintaining physical properties. In addition to the servicer’s fees there could be a number of reimbursement obligations for costs incurred. These cost reimbursement provisions should describe the types of costs that will be reimbursable (such as costs to foreclose or evict a borrower from a property, maintaining property, accounting for locked out borrowers, etc.) and include requirements for detailed accounting documentation, to ensure both parties clarity in tracking costs paid and avoid disagreements later.
While servicers regularly employ nonjudicial foreclosure remedies, it is always a good practice to spell out the procedures for both parties in the event that such proceedings become necessary. For example, to protect the servicer against spurious claims from a borrower, many servicers will seek to be given the right to place any forward-looking notices directly with the borrowers in whichever manner is deemed appropriate and changing from time to time.
Specifically, the servicer may want to require borrowers to provide it with a monthly status update for any delinquent loans and grant the servicer the power to place all necessary notices required by law. Many servicers will seek to be named as additional insureds under the loan or obligation under a title insurance policy.

Responsibilities and Obligations of a Loan Servicer

The roles and responsibilities of a loan servicer are determined by the specific terms of the loan servicing agreement. However, it is generally expected that the loan servicer will collect monthly mortgage payments, make disbursements of funds, answer inquiries, manage escrow accounts, and act as a point of contact for communications with the borrower.
A loan servicer may have one or more of these functions, none of them, or all of them depending on the agreement. Loan servicers may be required to follow certain guidelines when handling borrower inquiries and complaints. For example, a loan servicer may be required to give the borrower written notice of any default or other material issue concerning the loan and provide the borrower with the repayment amount. The loan servicer may also be obligated to include a specific phone number on all correspondence with the borrower, and must respond to the borrower if contacted on that number.
The loan servicer will maintain all records relating to the mortgage loan. They keep track of all payments made by the borrower, charge late fees for delinquent payments, and provide payoff balances. Although the loan servicer will maintain those records, they do not have ownership over the mortgage. It is also important to point out that any inquiries or complaints with regard to the mortgage loan should be directed to the loan servicer and not the owner.

Regulatory Aspects of Loan Servicing

Federal regulations governing loan servicing are discussed primarily in the Real Estate Settlement Procedures Act, or "RESPA," codified at 12 U.S.C. § 2601 et seq., and Regulation X, codified at 12 C.F.R. Part 1024. RESPA requires that servicers respond to borrower requests in a timely manner, directs the manner in which qualified written requests ("QWRs") must be handled, and prohibits some undisclosed transfer fees in service contracts. It also requires that lenders keep careful records of payment history for each loan. RESPA rules also govern foreclosure-related transactions, force-place policies, and requirement of disclosures related to property taxes and insurance. Consumer Financial Protection Bureau ("CFPB") regulations pertaining to loans covered by RESPA, codified at 12 C.F.R. § 1024.25(c), require that loan servicers make additional disclosures to borrowers. These regulations govern the manner in which debtors must be provided certain disclosures related to mortgage servicers. Specifically, they require that: Loan servicers may not refuse to communicate with approved third-party servicers. The Equal Credit Opportunity Act’s "Credit Practices Rule" (codified at 12 C.F.R. § 1022) has additional provisions governing certain loan agreements. Some of these provisions apply specifically to contracts calculated on a simple interest basis. Specifically, these provisions prohibit "unconscionable contract terms," and prohibit lenders from charging certain fees related to the following: Federal laws enforceable through the CFPB provide protections to consumers for electronic transfers of funds. These protections, which inter alia apply to "loans" must be afforded to borrowers. See 15 U.S.C. §§ 1693 et seq., and 15 C.F.R. § 205.1 et seq. In addition to federal protections for loan servicing agreements, there are also various due-on-sale provisions in property agreements that govern the ability of a lender to collect on certain loan servicing agreements, including 15 U.S.C. § 1703, codified at 12 C.F.R. 1024.30 et seq., as well as various provisions of the Real Estate Settlement Procedures Act. These laws require that a mortgage lender and a barrower keep certain records, and make them available in accordance with a formula prescribed by Congress. Moreover, some states have specific requirements that loan servicers and mortgage lenders describe the relationship between the barrower and the mortgage lender. For instance, North Carolina has enacted restrictions over the way in which creditors must describe the scope of the relationship with barrowers. See N.C.G.S.A. § 24-8. In North Carolina, loan servicers must comply with specific prohibitions that are intended to protect the lessors and lessees of landowners. In this context, loans made on "marble holed land" is prohibited by law unless a lease is signed due to the conveyance of such land. See N.C.G.S.A. § 29A-1 & Appx.. Several states also have enacted unconscionability provisions with respect to leases, agreements related to secured transactions, and consumer contracts generally.

Common Challenges in Loan Servicing Agreements

While loan servicing agreements are put in place to regulate, and ideally to simplify, the process of continuing to do business after a loan has closed, disputes still arise over the terms and conditions of the loan servicing process and how those terms should be applied. Loan servicing agreements generally address such topics as: But just because those concepts are laid out in writing does not mean that they don’t remain the source of controversy and litigation. One very common point of contention in these agreements is when the agreement between the lender and the servicer is supposed to be terminated. If the servicer proposes to terminate its services two years after the redemption date, is the client obligated to continue with that business relationship for that long, or can the client unilaterally terminate the agreement without cause if it does not want to work with the servicer for that long? Knowing the answer to that question is essential to assuring that the lender’s business needs are met. Disputes over the time-frame of the loan may be complicated by issues of succession and delegation . For example, if the loan servicer that a lender was working with sells off a large number of loans to another lender, what happens to all those existing loan servicing agreements? Those agreements – and the obligations they specify – likely must go through the process of renegotiation with the new lender. Keep in mind that, under different circumstances, the new lender could also decide to deem the loan servicer to be in default. Default is therefore another topic of contention in these agreements that can prove controversial. Does the loan servicer need to send notification multiple times before it can be declared to be in default, or is one warning enough? What recourse does the lender have if the servicer defaults – can it simply cancel the agreement, or does it have to engage in further negotiations on new terms? Communication issues are at the heart of many other disagreements regarding these agreements. What constitutes adequate communication from the servicer to the lender? Is the servicer required to update the lender every time it makes a decision, or only on certain timelines? These terms will have to be spelled out specifically within the loan servicing agreement in order to avoid controversy.

Optimum Practices in Loan Servicing

Effective loan servicing is essential for minimizing risk, maintaining compliance, and enhancing customer satisfaction. Here are some recommended best practices for managing loan servicing agreements: Establish Clear Policies and Procedures: Develop comprehensive loan servicing policies and procedures that outline all critical aspects of the servicing process, including account management, collections, customer communication, payment processing, and problem resolution. Automate Whenever Possible: Automate as many loan servicing functions as possible to streamline processes and reduce the risk of human error. This includes auto-decisioning of applications, automated account set-up, and automated account status updates. Prioritize Risk Management: Establish risk management and compliance programs to proactively identify and mitigate potential risks and ensure full compliance with applicable state and federal laws and regulations. This includes implementing regular compliance training for personnel involved in loan servicing. Leverage Data Analytics: Take advantage of data analytics tools to gain insights into customer behavior and preferences. This can help tailor product offerings and service delivery to align with customer needs. Continuously Monitor Vendor Performance: Regularly review and evaluate the performance of loan servicing vendors to ensure they meet the terms of the agreement and provide satisfactory services. This is particularly important for third party debt collectors and other service providers that perform work on your behalf. Facilitate Transparent Communication: Ensure that customers have access to clear and transparent information about their accounts and any actions you will take with respect to their account. This fosters trust and transparency and can discourage them from seeking legal remedies. Maintain Adequate Documentation: Keep detailed records of all account activity, customer communications, and compliance efforts. This will be invaluable if you need to demonstrate compliance with regulatory requirements or defend against consumer claims.

The Evolution of Loan Servicing

Traditionally, the key to loan servicing has been paper-based communications. In an industry that relies so heavily on contracts, there have always been huge volumes of documents to manage. Although most servicers took advantage of basic automation by investing in software such as Word and Excel, the three-step process of create, print and send has been the norm.
Today, even those steps can seem too slow and cumbersome. Incumbent servicers are now facing fierce competition from new entrants to the marketplace, including fintech firms specializing in technology solutions for the lending industry.
As they emerge in sectors such as peer-to-peer (P2P) lending, cryptocurrencies and tax relief funding, fintechs are driving the demand for a new kind of agility in loan servicing. Those using advanced automation and machine learning (ML) enable the market to accelerate. As servicers are now able to respond to changes in borrowing and economic conditions with remarkable speed, they are also able to customize their service provision based on highly dynamic criteria.
Automation and digitization will allow servicers to closely track the borrower lifecycle, assess the full credit history of a loan and dynamically evaluate whether their existing loan terms remain optimal at any given time . Easier access to the data generated by the billions of other transactions being processed through financial networks opens up opportunities to personalize loan packages to a huge range of niche borrower segments, instead of generalizing products. On the administrative side, this will enable teams to closely track payments, facilitate reminders and calculate charges automatically.
Even the rise of P2P lending—a sector which places less emphasis on the quality of the loan servicing process—will have a knock-on effect in the industry. As new lenders enter the market (or existing lenders open up additional funding streams), the overall level of cash will increase. This means that more loans will need to be organized and serviced. Earlier projections suggested that the total value of the U.S. P2P lending market would rise from $6 billion in 2014 to $158 billion in 2020.
Now, new research from Allied Market Research published Apr. 9 shows that the U.S. peer-to-peer (P2P) lending market alone is projected to grow by 22.5 percent per year from 2017 to 2023.
In order for this to become a reality, the lending processes themselves will need to be faster and more efficient than before. Just as with corporate debt markets, this will drive the increased demand for pricing tools, underwriting services and risk management.
Automation holds the key to enabling servicers to keep up with these new demands. Within five years, the industry will need to become much more responsive.