A New Year Brings New Mortgage Rules

The New Year ushers in major changes to the residential mortgage industry.  On January 10, 2014, the long awaited, and much debated “Ability-to-Repay” Rule of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) go into effect.

A Little Background

Dodd-Frank’s Ability-to-Repay Rule requires residential mortgage lenders to make a good faith determination about a borrower’s ability to repay a loan in accordance with its original terms.  This new requirement was developed in response to the types of no-doc, low-doc, interest only, or teaser mortgages that preceded the Foreclosure Crises of the last half decade.  Under these types of loans, the borrower could be placed in a loan that they could not afford to pay-off from its inception, or payments could become unmanageable after the end of an introductory period.  It is thought that these types of unconventional loans played a significant role in the foreclosure crises.  To combat irresponsible lending practices, Congress included a requirement that lenders determine if a borrower can afford a residential mortgage loan before making that loan.  The rule-making authority for this provision of Dodd-Frank has been granted to the recently formed Consumer Financial Protection Bureau (CFPB).

What Factors Must a Lender Consider In Making Its Determination About a Borrower’s Ability-to-Repay?

Under the final rules issued by CFPB, a lender must obtain verifiable third-party documentation (thus eliminating the no-doc and low-doc mortgages of the past) that takes in consideration a number of factors in determining a borrower’s ability to meet a proposed loan’s terms.  These eight factors should generally include at a minimum in such a determination:

  1.  The Borrower’s reasonably expected income and assets;
  2. current employment status;
  3.  monthly payments of the considered loan;
  4. monthly payments of any simultaneous mortgage loan (i.e. second mortgage);
  5. monthly payments on mortgage related obligations;
  6. other debts;
  7. monthly debt-to-income ratios; and
  8. credit history.

In making the determination, a lender may not use any introductory rate or terms, and must be based upon the highest possible payment in the first five years of the loan.  This determination is made based on the actual conditions at the time the loan is made, and may not be based on future expectations of a borrower’s credit worthiness.  Lenders must maintain the records they used for making a determination for a period of three years.

Why Should Lenders Care About the New Ability-to-Repay Rule?

The Ability-to-Repay Rule creates significant potential liability for lenders from unhappy or defaulted borrowers who could sue claiming that the loan should not have been made to them.  A violation of the Ability-to-Repay Rule may result in the Borrower receiving statutory damages under TILA, special statutory damages, court costs and attorney’s fees.  In addition, the rule provides an affirmative defense in a foreclosure.

How Can a Lender Protect Itself?

To combat this, CFPB has defined certain loan standards (Qualified Mortgages) by which complying loans are presumed to have met the Ability-to-Repay requirement.  Lenders that make Qualified Mortgage compliant residential mortgage loans will be “Qualified” for some degree of legal protection from suits related to the Ability-to-Repay Rule.  The degree of protection will depend on the nature of the loan issued.  This will be discussed further below.

What Mortgages Qualify for Protection?

To be a Qualified Mortgage (QM), the loan:

  • May not contain one of the prohibited mortgage features (interest-only, balloon, negative amortization, or terms longer than 30-years).
  • Total Points and Fees may not exceed 3% of the loan value. (This would include any closing fees from service providers related to the lender, including affiliated title or escrow companies.)
  • May not result in a borrower having a Debt-to-Income Ratio above 43%.
  • Are certain types of Rural Balloon Mortgages.  (This is a type of specific mortgage exempted by Dodd-Frank and must meet certain strict requirements.)

In addition to the qualifications set-forth above, CFPB has created a temporary QM category for those loans meeting FannieMae, FreddieMac, HUD, VA, or Department of Agriculture Rural Housing underwriting guidelines.  This exemption will phase at the end or the Federal Conservatorship of FannieMae and FreddieMac, and when these federal agencies issue their own QM rules.  Until then, they may provide an additional avenue for lenders to qualify for legal protection.

How is a Lender Protected?

QM compliant mortgages qualify for legal protection from the Ability-to-Repay Rule.  This protection falls into two categories depending on the type of loan.

Prime Mortgages (those at or near the prime interest rate) are granted the highest level of protection. The QM rules create a “safe harbor” for lenders meeting QM standards when issuing a prime mortgage loan.  This safe harbor shields the lender from borrower challenges under the Ability-to-Repay Rule.

Sub-Prime Mortgages (loans with interest rates 1.5% higher than the prime rate) are granted less protection.  These sub-prime loans are granted a “Rebuttable Presumption” of compliance with the Ability-to-Repay Rule.  Under this protection, a lender is presumed to have complied with the Ability-to-Repay Rule if the loan is QM compliant.  This presumption may be rebutted by a borrower if they can prove that the lender did not properly consider its ability to pay the loan.

Must All Residential Mortgages be Qualified Mortgage to Avoid Violating the Ability-to-Repay Rule?

No, a non-Qualified Mortgage does not violate the Ability-to-Repay Rule of Dodd-Frank.  A lender may make such loans provided that they make a good faith determination of the borrower’s ability to repay the loan.  The lack of Qualified Mortgage status disqualifies the loan for the legal protection under the CFPB rules.  It is however, unlikely, that most lenders will be willing to issue non-Qualified Mortgage Loans as a result of the lack of this protection.

Are the Qualified Mortgage Rules the Same Thing as the Qualified Residential Mortgage Rules?

No, despite very similar names, QM and QRM are two different products of Dodd-Frank.  As discussed above, the QM rules provide a minimum to qualify for legal protections from the Ability-to-Repay Rule.  The Qualified Residential Mortgage Rules (QRM) are being designed to help define “low risk” mortgages for sale in the secondary mortgage market.  Presently the QRM rules are still being developed by six Federal Agencies.  There is a strong push from the banking industry to have the QRM standards match those for QM.  What standards are adopted will have an effect on a lender’s ability to sell a mortgage loan on the secondary market, and ultimately the amount of credit available to consumers.

What Effect Will This Have on The Residential Mortgage Market?

The effect of these new rules has been hotly debated over the past year.  There is significant concern that debt-to-income ratio limits may make a home mortgage unobtainable to the poor and recent college graduates.  Further the 3% fee cap may result in higher minimal loan amounts, limiting loan options for less-expensive houses.  Yet, others point out that 95% of current loans would meet the QM standards.  The year 2014 will likely be a year of uncertainty and change in the world of residential mortgages.  Only time will tell.