Is the 43% debt-to-income (DTI) ratio threshold a strong indicator of a homebuyer's ability-to-repay?

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The Consumer Financial Protection Bureau (CFPB) is shaking up the mortgage market with its new proposal for qualified mortgage (QM) criteria.

Following the disastrous lending standards that led to the 2008 recession and housing crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act amended Regulation Z, which implements the Truth in Lending Act (TILA) to establish QM definitions. Lenders who issue residential mortgages that meet QM criteria are given protection from penalties that arise from noncompliance with the broader ability-to-repay (ATR) rules.

A lender may still originate mortgages that do not meet the QM standard, but doing so exposes the lender to more risks. To cover the increased risk, non-QM mortgages tend to be less desirable for lenders and more expensive for consumers. Thus, QM mortgages continue to be preferred.

QMs may be originated under the rules for the:

  • general QM;
  • temporary QM or government-sponsored enterprise (GSE) Patch, set to expire on January 10, 2021;
  • small lender QM; and
  • balloon-payment QM. [12 Code of Federal Regulations §1026.43(c)-(f)]

With its new proposed rule, the CFPB is amending the general QM definition and, when the new general QM takes effect, eliminating the GSE Patch.

Related article:

With the GSE Patch expiring in 2021, what will happen to the qualified mortgage rule?

Currently, the general QM definition includes loans that meet six criteria:

  1. Regular periodic payments. No interest only, negative amortization or balloon payment features are allowed. [12 CFR §1026.43(e)(2)(i)]
  2. mortgage term of 30 years or less. [12 CFR §1026.43(e)(2)(ii)]
  3. Maximum points and fees of no more than 3% of the principal amount for mortgages of $109,898 or more in 2020, adjusted annually for inflation. [12 CFR §1026.43(e)(3)]
  4. Monthly payments used to determine repayment ability are to be based on a full amortization schedule, using the maximum interest rate that applies during the first five years. [12 CFR §1026.43(e)(2)(iv)]
  5. Assets, debts and two years’ income are to be verified and documented. Income used needs to be verified, stable and expected to continue. The lender is responsible for verifying the most recent two years’ employment. [12 CFR Appendix Q Parts A-B]
  6. The maximum total debt-to-income (DTI) ratio, also known as the back-end DTI, is 43%. [12 CFR §1026.43(e)(2)(vi)]

The ineffective DTI measure

The most significant change the CFPB proposes for the general QM is to eliminate the DTI ratio requirements. In place of the DTI measure, the CFPB proposes to use a pricing threshold, measured by comparing a loan’s annual percentage rate (APR) to the average prime offer rate (APOR).

For example, under the proposed standard, the loan meets the general QM requirements when the loan’s APR is within two percentage points of the APOR for a comparable transaction.

The Mortgage Bankers Association (MBA) recently made known their support for the change, claiming the new loan pricing threshold is still a strong indicator of a borrower’s ability to repay. Further, it also opens up QMs to a broader swathe of the population who may not have been able to qualify under the old requirements.

How does this work?

When lenders produce loan terms, their APR reflects the interest rate and fees. For a high-risk borrower — including a borrower with a high DTI — the APR would be relatively high compared to the applicable APOR. Thus, comparing APR with an equivalent APOR includes the DTI measure in a roundabout way, but allows for greater flexibility. For example, a borrower with a high DTI but a low risk of default in terms of credit history, employment status and assets, may still receive an acceptable APR and thus qualify under the new QM standards.

In other words, the pricing criteria puts more faith in the lender’s ability to identify a borrower’s ability to repay.

Stay tuned for the CFPB’s final ruling. In the meantime, the Bureau is barreling ahead with its plans, which will extend the GSE Patch until the final rule amending the general QM is set and takes effect.