Real estate explained: Ability-to-repay rules

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

The ability-to-repay rules apply to all residential mortgages — any consumer credit transaction secured by a one-to-four residential property — 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)]

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)]

Most carryback sellers are exempt from the ability-to-repay rules, as the rules only apply to creditors who have extended consumer credit more than five times in the prior calendar year. [12 CFR §1026.2(a)(17)]

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

To fulfill this requirement, lenders need 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)]

Lenders also need to verify mortgage application information with reliable third-party records, such as:

• 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 (common during the Millennium Boom) since they do not meet this third-party verification requirement.

Lenders also need to determine a borrower’s ability to repay based on substantially equal monthly payments for a fully amortized 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)]

However, prepayment penalties on an early payoff of the mortgage may not be charged on consumer mortgages under the ATR rules. [12 CFR §1026.43(g)]

A qualified mortgage is a more specific definition carved out by the ability-to-repay rules. When a loan meets the qualified mortgage criteria, it is presumed to comply with the ability-to-repay 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 palatable for lenders and more expensive for consumers. Thus, QM mortgages continue to be preferred.

Four types of QMs have been established, the:

• general QM;
• temporary QM;
• small lender QM; and
• balloon-payment QM. [12 Code of Federal Regulations §1026.43(c)-(f)]

Qualified mortgages of the general and temporary types may be originated as consumer mortgages by all lenders. Balloon-payment and small lender qualified mortgages may only be originated by small lenders.

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. A mortgage termof 30 years or less. [12 CFR §1026.43(e)(2)(ii)]
3. Maximum points and feesof no more than 3% of the principal amount for mortgages of $107,747 or more in 2019, 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 ratethat 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 temporary QM carries the same standards for regular periodic payments, maximum mortgage terms, and total points and fee restrictions. But instead of the DTI limits in the general QM, loans qualifying under the temporary QM definition need to be eligible to be purchased, insured or guaranteed by a government agency or one of the government-sponsored entities (GSEs), Fannie Mae or Freddie Mac. This includes Federal Housing Administration (FHA)-insured mortgages and U.S. Department of Veterans Affairs (VA)-guaranteed mortgages, among others.

This temporary QM definition is known as the GSE Patch and it expires January 10, 2021.

A report by the Consumer Financial Protection Bureau (CFPB) finds that approximately 16% of residential mortgages originated in 2018 were issued under the temporary QM definition, using the GSE Patch. When the patch expires, will the mortgage market lose 16% of its originations due to an inability to qualify under the general QM?

It’s possible that the mortgage market will see fewer originations, but the drop won’t likely be a full 16%. In some cases, consumers will be able to borrow through private lenders who are willing to take on clients with higher DTIs. But this will come with higher rates and fees, and therefore reduce buyer purchasing power, cutting into the amount homebuyers qualify to purchase and thereby creating more obstacles for the housing market.

Rather than making the temporary QM permanent, the CFPB’s current plans are to let the GSE Patch expire, though they are considering a temporary extension to ensure a smoother transition (and perhaps allow homebuyers more time to reduce their DTIs and qualify under the general QM). They are also considering changing the general QM definition to be more inclusive, so that some of the mortgages which otherwise would be originated with the GSE Patch may be allowed by the general QM.

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 United States Code §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. The lender is also 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 action 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]

Read more about the GSE Patch expiration here.

Read the CFPB’s general comparison of ability-to-repay requirements with qualified mortgages here.

firsttuesday students, read more in Mortgage Loan Brokerage and Lending: Chapter 10: Ability-to-repay and qualified mortgage rules, accessible via your student homepage.