Ability-to-repay, qualified mortgage, qualified residential mortgage: are you lost yet?  Read this article to get through the maze of new and proposed rules affecting residential mortgage lending.

Re-regulating lenders

To fans of deregulation: it’s time to admit you were wrong. During the free-wheeling days of the Millennium Boom, lenders made loads of mortgages to appease the secondary market’s appetite for mortgage-backed bonds. They paid no attention to whether applicants were able to sustainably pay these mortgages. A few years after the mortgages were made, borrowers began to default. The rest is ignominious history.

In other words, lenders had their chance to make a case for a deregulated mortgage market, and they totally botched it. And now regulators are taking residential mortgage lending back to fundamentals first learned in the 1930s.

One of the most significant regulatory changes will go into effect for all mortgage applications received on or after January 10, 2014: the ability-to-repay rules.

The ability-to-repay rules are part of Regulation Z, the regulation which implements the Truth-in-Lending Act (TILA). They require residential mortgage lenders to make a “reasonable and good faith effort to verify that the applicant is able to repay the loan.” [12 Code of Federal Regulations §§1026.43 et seq.]

Which mortgages are subject to the ability-to-repay rules?  A residential mortgage is any consumer credit transaction secured by a one-to-four unit residential property.

The ability-to-repay rules apply to all residential mortgages, except:

  • open-ended credit plans, such as home equity lines of credit (HELOC);
  • timeshares;
  • reverse mortgages;
  • bridge loans; and
  • construction-to-permanent mortgages with construction phases of less than 12 months. [12 CFR §1026.43(a)]

Mortgages subject to the ability-to-pay rules are called covered transactions.

Editor’s note — Remember your TILA basics: loans for investment, business or agricultural purposes are not consumer credit. These loans are not classified as residential mortgages, even if they are secured by one-to-four unit residential properties. [12 CFR §1026.2(a)(12)]

Additionally, the ability-to-repay rules apply to “creditors.” A person is a creditor if they extended consumer credit more than five times in the prior calendar year. Thus, most carryback sellers will be exempt from the ability-to-repay rules. [12 CFR §1026.2(a)(17)]

Ability-to-repay rules and penalties for violations

First, the ability-to-repay rules require lenders to consider an applicant’s ability to repay based on:

  • current or reasonably expected income or assets;
  • current employment status;
  • the monthly payment on the residential mortgage;
  • the monthly payment on any simultaneous residential mortgage, such as a second lien;
  • the monthly payment for mortgage-related obligations, such as taxes and insurance;
  • current debt obligations, alimony, and child support;
  • the monthly debt-to-income ratio (DTI) or residual income; and
  • credit history. [12 CFR §1026.43(c)(2)-(3)]

Second, lenders aren’t allowed to simply assume information provided in a mortgage application is correct. Lenders are to verify mortgage application information with reliable third-party records. Reliable third-party records include:

  • tax returns;
  • W-2s;
  • payroll statements;
  • bank or investment account statements;
  • records from the applicant’s employer;
  • government records on benefits or entitlements; and
  • credit reports. [12 CFR §1026.43(c)(4)]

For example, lenders are prohibited from making “no-income, no-asset” documentation mortgages since they do not meet this third-party verification requirement.

Residential mortgage lenders are required to make a “reasonable and good faith effort to verify that the applicant is able to repay the loan.”

Third, ability-to-repay rules require a lender to determine ability-to-repay based on substantially equal monthly payments that would fully amortize the loan. No two monthly payments can vary by more than 1%. Thus, balloon payment loans, interest-only loans and negative amortization loans are not strictly prohibited. However, the borrower is to be underwritten based on (largely) fixed payments that would fully amortize the loan. [12 CFR §§1026.43(c)(5)(i); 1026.43(c)(5)(i)(B)-(C)]

That’s the extent of the ability-to-repay rules. If you’re thinking they’re very general, you’re right. There are no hard rules about loan-to-value ratios (LTV), DTI or credit score requirements in the ability-to-repay rules. Lenders are to adhere to their guidelines and provide compliance and oversight procedures sufficient to pass muster.

Thus, lenders have leeway to offer applicants risky products. However, the riskier the mortgage product, the greater the lender’s potential risk of noncompliance with the ability-to-repay rules. (More about those penalties later.)

Society is thrust into the position of having to trust the lender will to do their job and underwrite the mortgage. Even if lenders are cowed by the severe penalties for failing to comply with the ability-to-repay rules, how is an applicant to ensure lenders are acting “reasonably and in good faith?”

The qualified mortgage

To answer that question, you need to enter the world of qualified mortgages. A qualified mortgage is a more specific definition carved out by the ability-to-repay rules. If a loan meets the qualified mortgage criteria, it is presumed to comply with the ability-to-repay rules.

Lenders will comply with the ability-to-repay rules, one way or the other.  However, they have a choice of how to comply:

  • by making mortgages under the more flexible, but riskier general ability-to-repay rules; or
  • by making mortgages under the less risky, but stricter qualified mortgage definitions.

For mortgage applicants, the qualified mortgage exemplifies the safest features of residential mortgages. For lenders, the qualified mortgage offers a more specific roadmap which, if followed, automatically allows the loan to comply with the ability-to-repay rules.

To be considered a qualified mortgage, a residential mortgage is to meet the following six standards:

1.  Regular and substantially equal periodic payments. The mortgage may not allow negative amortization of the principal, permit the applicant to defer repayment of principal or result in a balloon payment. [12 CFR §1026.43(e)(2)(i)]

2.  Mortgage terms. The amortization period for payment of a qualified mortgage may not exceed 30 years. Gone are the days of the 40-year and 50-year mortgages. [12 CFR §1026.43(e)(2)(ii)]

3. Points and fees thresholds. The maximum total points and fees charged on a qualified mortgage are limited to 3% of the total loan amount for mortgages of $100,000 or more, indexed to inflation. [12 CFR §1026.43(e)(3)(i)-(ii)]

Points and fees include:

  • any charge imposed by the lender and payable by the applicant, indirectly or directly, EXCEPT:
    • interest;
    • Federal Housing Administration (FHA) mortgage insurance premiums (MIPs);
    • Department of Veterans Affairs (VA) funding fees;
    • United States Department of Agriculture (USDA) guarantee fees;
    • private mortgage insurance (PMI) premiums;
    • bona fide third-party charges not retained by the lender, loan originator, or their affiliates [12 CFR §1026.32(b)(1)(D)]; and
    • excluded bona fide discount points [12 CFR §§1026.32(b)(1)(i)(E)-(F); (b)(3); 12 CFR §1026.43(e)(3)(i); 12 CFR §1026.32(b)(1); 12 CFR §1026.4(a)];
  • loan originator compensation, including fees paid to a mortgage broker or other loan originator [12 CFR §1026.32(b)(1)(ii)];
  • real estate related fees such as title insurance fees, escrow fees, appraisal fees, etc., when the lender or an affiliate receives compensation in connection with the fees [12 CFR §1026.32(b)(1)(iii)];
  • insurance premiums paid before closing for credit insurance, credit property insurance, debt cancellation or suspension coverage payments or other life, accident, health or loss-of-income insurance where the lender is the beneficiary [12 CFR §1026.32(b)(1)(iv)]; and
  • the maximum prepayment penalty, if allowed. [12 CFR §1026.32(b)(1)(v)]

4. Monthly payment calculations. Monthly payments are to be based on a fully amortized payment schedule, using the maximum interest rate that may apply during the first five years of the mortgage. [12 CFR §1026.43(e)(2)(iv)]

5. Verification of income, assets and debts. Qualified mortgages have their own set of underwriting criteria for verifying income, asset and debts. These underwriting requirements are contained in Appendix Q of the Truth-in-Lending Act (TILA).

The requirements are extensive, but generally: income, assets and debts are to be verified using third-party sources. The applicant’s income needs to be stable and expected to continue for at least three years into the requested mortgage. The lender is responsible for verifying the most recent two years’ employment. The applicant will need to explain gaps in employment longer than one month. [Appendix Q to 12 CFR §1026 Parts A-B]

An applicant who owns 25% or more of a business is considered self-employed. Self-employed income may only be used to qualify if the applicant has been self-employed for at least one year. If the applicant has been self-employed between one and two years, the applicant is to provide at least two years of documented previous employment in the same line of work. [Appendix Q to 12 CFR §1026 Part D]

6. DTI cap. The maximum total DTI is 43%.

The other qualified mortgages

So, now we have general, but vague ability-to-repay rules which control mortgage origination processes. To provide greater clarity, the qualified mortgage definition gives lenders more specific guidelines on how to comply with the ability-to-repay rules. Now, we come to the exceptions to these two rules.

There are four types of qualified mortgages: the general qualified mortgage, the temporary qualified mortgage, the small lender qualified mortgage and the rural balloon-payment qualified mortgage.

In addition to the general qualified mortgage definition, the Consumer Financial Protection Bureau (CFPB) has defined three subcategories of qualified mortgages:

  • the temporary qualified mortgage [12 CFR §1026.43(e)(4)];
  • the small lender qualified mortgage [12 CFR §1026.43(e)(5)]; and
  • the rural balloon-payment qualified mortgage. [12 CFR §1026.43(e)(6); 12 CFR §1026.43(f)]

The temporary qualified mortgage

The temporary qualified mortgage is a transitional qualified mortgage for lenders originating:

  • mortgages subject to insurance or guarantees by the federal government; or
  • originations sold to Fannie Mae and Freddie Mac.

During the temporary transitional period, Fannie Mae and Freddie Mac will adjust their underwriting guidelines to meet the qualified mortgage definition.

Temporary qualified mortgages are to meet the first three criteria of the general qualified mortgage definition:

  • regular periodic payments, and no negative amortization, interest only or balloon payment arrangements;
  • a maximum mortgage term of 30 years; and
  • points and fees restrictions.

In addition, to meet the requirements for a temporary qualified mortgage, the mortgage needs to be eligible for:

  • purchase by Fannie Mae;
  • purchase by Freddie Mac;
  • insurance by the FHA;
  • guarantee by the VA;
  • guarantee by the USDA; or
  • insurance by the Rural Housing Service (RHS). [12 CFR §1026.43(e)(4)]

The “temporary” qualified mortgage does not restrict the total DTI to 43%. It also temporarily defers to Fannie, Freddie and the government agencies for underwriting procedures (as opposed to Appendix Q).

The temporary qualified mortgage designation will sunset for each government agency on the earlier of:

  • each agency’s issuance of a qualified mortgage definition; or
  • January 10, 2021. [12 CFR §1026.43(e)(4)(iii)]

The small lender qualified mortgage and rural balloon- payment qualified mortgages

Small lenders, such as smaller credit unions and state-chartered banks, are traditionally more inclined to make nonconforming mortgages. They also have a higher cost of funds than do the Big Banks. The CFPB created the small lender qualified mortgage to maintain a source of nonconforming mortgage money, and to allow small lenders to compete with Big Banks. The small lender qualified mortgage definition has less stringent fee and underwriting requirements than the general qualified mortgage definition.

Small lenders are defined as:

  • lenders whose assets do not exceed $2 billion at the end of the preceding calendar year, adjusted annually for inflation; and
  • lenders who, together with all affiliates, extended 500 or fewer first-lien covered transactions in the preceding calendar year. [12 CFR §1026.43(e)(5)(i)(D)]

Small lenders have greater flexibility to offer different products to applicants, as they are not subject to Appendix Q requirements. Additionally, small-lender qualified mortgages are not subject to 43% DTI cap. [12 CFR §1026.43(e)(2)(iv)]

However, small lender qualified mortgages:

  • may not negatively amortize;
  • may not have a loan term greater than 30 years;
  • are subject to the 3% total points and fees caps established under the general qualified mortgage rule; and
  • are based on a monthly payment schedule that fully amortizes the loan using the maximum interest rate that may apply during the first five years of the loan.

The CFPB also created a definition of qualified mortgages for loans with balloon payments — but only for small lenders. During the boom, subprime lenders and Big Banks got ahold of the balloon-payment mortgage, and we all got front-row seats to a financial Hindenburg. Historically, however, small community banks have had very low default rates on balloon-payment mortgages (here’s a shocker: the CFPB believes this is because they actually underwrote the mortgages before making them.)

Small lenders are the main source of financing in rural and underserved areas. Thus, the CFPB carved out a balloon-payment mortgage qualified mortgage to preserve access to credit in those areas.

A balloon-payment qualified mortgage needs to meet all the requirements of a small lender qualified mortgages.

Additionally, the balloon-payment qualified mortgage has specific rules:

  • the loan will have a fixed interest rate and periodic payments that fully amortize over 30 years or less;
  • the loan will have a term of five years or longer [12 CFR §1026.43(f)(1)(iv)];
  • the loan may not be sold after origination to an entity that is ineligible to make balloon-payment qualified mortgages. [12 CFR §1026.43(f)(1)(v)]

For mortgage applications received between January 10, 2014 and January 9, 2016, a loan only qualifies as a balloon-payment qualified mortgage if:

  • more than half of the lender’s first-lien covered transactions in the prior calendar year were secured by properties in rural or underserved areas [12 CFR §1026.35(b)(2)(iii)(A)]; or
  • it is retained in the small lender’s portfolio. [12 CFR §1026.43(e)(6)(ii)]

On and after January 10, 2016, a small lender may only make a balloon-payment qualified mortgage if more than half of the lender’s first-lien covered transactions in the prior calendar year were secured by properties in rural or underserved areas.

Related article:

CFPB: General Comparison of Ability-to-Repay Requirements with Qualified Mortgages

Penalties, and ability-to-repay vs. qualified mortgage

Lenders are always watching their bottom line – and they’re on high alert now in preparation for the imminent regulatory changes. Violations of the ability-to-repay rules carry stiff penalties. An applicant may bring an action to show the lender has violated the ability-to-repay rules by either:

  • filing a court action against the lender within three years of the violation (loan closing) [15 USC §1640(e)]; or
  • using a violation of the ability-to-repay rules as a defense against a lender’s foreclosure action. [15 USC §1640(k)]

A lender who violates the ability-to-repay rules as determined by court action will repay all finance changes and fees paid by the applicant. Further, the lender is liable for the applicant’s actual money losses, statutory penalties under the TILA, court costs and attorney fees. [15 USC §1640(a)(4)]

A lender who violates the ability-to-repay rules under a defense against foreclosure recoupment act is liable for actual and statutory money losses and penalties, as well as costs and attorney’s fees, plus up to three years’ finance charges and fees. The finance charge includes any charge paid by the applicant in connection with the mortgage, such as interest, origination fees, etc. [15 USC §1640(k)(2); 12 CFR §§1026.4]

From a lender’s liability standpoint, compliance with the qualified mortgage guidelines works on one of two levels:

  • as a safe harbor with no liability for lenders making mortgages except for loans that are higher-priced covered transactions; and
  • as a rebuttable presumption for lenders making loans which are higher-priced covered transactions. [12 CFR §1026.43(e)(1)]

The vast majority of mortgages are not higher-priced covered transactions. Thus, most covered transactions will give lenders safe harbor protections against an applicant’s claims. A safe harbor loan eliminates the lender’s liability, provided a set of conditions has been met in good faith. Thus, to prevail on a claim the lender violated ability-to-repay rules, the applicant needs to prove the mortgage does not meet the definition of a qualified mortgage. If the loan is found to meet the qualified mortgage criteria, the case may proceed no further: the lender wins. (That’s the theory, anyway…)

For higher-priced covered transactions, the rebuttable presumption allows the applicant to rebut the claim the lender complied with the ability-to-repay rules, even if the lender met the qualified mortgage guidelines. [12 CFR §1026.43(e)(1)(ii)]

Editor’s note — The rules for higher-priced covered transactions are detailed and, well, convoluted. We’ll cover this in a separate article.

What does this mean for your applicant?  Most lenders will stick to making qualified mortgages. Large banks will not want the responsibility or liability of straying from the flock to offer more exotic mortgage products.

However, because of the special small lender qualified mortgage definition, smaller banks will have greater latitude to make mortgages to applicants with nonconforming or nontraditional mortgage needs. That doesn’t give smaller banks a pass on ability-to-repay requirements, but it certainly makes them friendlier to applicants who, say, have high DTIs, but substantial assets.

A few larger lenders may choose to forego the safety of the qualified mortgage and offer loans based on the ability-to-repay rules. But these offerings won’t be of the subprime variety. Expect these lenders to offer niche products catering to the high-end mortgages: again, the high-DTI, but high-asset, low-LTV crowd.

Additionally, the market depends on Fannie Mae and Freddie Mac to purchase residential mortgages. Come January 10, that means most lenders will be chasing QMs and following the rules under the temporary qualified mortgage definition.

The pending qualified residential mortgage

Another factor which will further push lenders towards offering only qualified mortgages is the qualified residential mortgage (QRM). As we’ve discussed, qualified mortgages are an option for lenders to comply with the ability-to-repay rules.

Mortgages which fall under the QRM definition are exempt from the 5% risk retention rule.

The QRM is a separate definition, dealing with risk retention by the lender who originates the mortgage. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) requires lenders to keep 5% of the mortgages they sell into the secondary market (securitize) on their books. Mortgages which fall under the QRM definition are exempt from this 5% risk retention rule.

Regulators are still hashing out the QRM definition, with lenders in full attendance. The newest proposal was released in late August 2013. Earlier drafts of the QRM contained a maximum 80% LTV restriction, but that restriction has since been removed. (Can you hear the lenders, builders and brokers cheering over that one?)

Related articles:

CFPB issues mortgage underwriting standards: down payment requirement to come
The 20% solution: personal savings rates and homeownership

The newest proposed definition has brought the QRM in alignment with the qualified mortgage. This not only makes it easier for lenders to comply (score two for the lenders), but will almost certainly restrict lending to the QM definitions. Lenders want the profits, not the risk of liability for making bad loans.

Most homebuyers won’t recognize the terms “qualified mortgage” or “qualified residential mortgage.”  However, these definitions will heavily impact their ability to borrow in contrast to the wild and wooly days of the past two decades.

These rules will also likely slow the influx of new buyers into the real estate market. Homebuyers will have to be prepared with sufficient credit and income to fund the purchase of a home. But the real estate and mortgage markets will ultimately benefit from the stability.

When homebuyers can actually pay for the mortgage they have taken out, the market is insulated from wholesale default. Alas, it won’t stop homebuyers from overbidding on properties, up to the very edge of their ability, ARMs included. Speculators’ influence will be tempered (as well as their profits), but not removed.

2014 will be a bumpy year, after the mortgage industry starts to put these (long stalled) regulations to work. We’ll see how lenders slip around the rules, as they will. Should be good for a few instructive lawsuits…