What CFPB’s New Ability-to-Pay Rule Means to You and Your Mortgage

shutterstock_113241547

The Consumer Financial Protection Bureau finally did what financial industry shareholders failed to do for themselves a decade ago.  They passed a sweeping 800+ page regulation earlier this month, decreeing that before banks grant a mortgage, they should make a good-faith effort to determine that the borrower will be able to pay them back.

The regulations, issued under the authority of the Dodd-Frank financial industry reforms, amend Regulation Z, and will become effective – sort of – on January 14, 2014.

In some ways, the set of regs is a sop to the financial industry, which was looking for a way to limit liability on future loans gone bad, in a ‘sue your lender-happy’ mortgage environment. One plaintiff strategy used against banks to hammer them into writing down mortgage balances has been the assertion that the bank lent the homeowner money, knowing they likely would not be able to make the payments and that the bank would soon foreclose on a greatly appreciated home.

The regulation’s chief provision was the establishment of a ‘safe harbor.’ If the lender jumps through certain hoops when they issue the mortgage, the regulations prevent consumers from challenging the mortgage later. The lender is protected from lawsuits – a provision that the lending industry believes will free up more capital to loosen up a tight mortgage market.

Here are the hoops – and what they mean:

Lenders have to verify income and credit information from a reasonably reliable third-party source.

A few years ago,  if you were a tipped employee, or you were self-employed and had hard-to-verify income, you could work around the fully-documented loan requirements, pay a little bit more interest, and get a ‘stated income’ loan? It’s going to be harder to do that in the future. In order for the mortgage to qualify under the safe-harbor provisions, the bank is going to need to see some proof. In practice, that will probably mean you will have to declare that income, so it shows on your tax return – and pay taxes on it. Like you were supposed to be doing all along.

The allowable debt-to-income ratio is capped at 43 percent.

That is, once the mortgage is issued, the borrower’s fixed debt service costs, including the mortgage, credit cards, car loans, student loan debt, and nearly anything else recorded by the credit bureaus, cannot be greater than 43 percent of pre-tax income. This isn’t too radical a change – 43 percent is close to what the VA (Veterans Administration), FHA (Federal Housing Administration) and Fannie and Freddie are willing to allow already, with minor variations between them.

For adjustable mortgages, the debt-to-income ratio must be calculated at the highest payment contractually possible within the first five years of the mortgage.

That is, if you have a mortgage payment of $1,500 per month, but if interest rates rise, and the bank has the right to increase your payment to $1,900 per month as a result at any time during the first five years of the life of the loan, the DTI ratio must be calculated based on the $1,900 per month payment, not the $1,500 per month payment. This limits the use of the adjustable rate mortgage to help marginal homeowners qualify for mortgages they couldn’t touch under fixed-rate terms.

Qualified Mortgages cannot be for terms longer than 30 years.

Towards the end of the real estate boom, it was getting so hard for people to qualify for 30 year mortgages that lenders were rolling out extended financing – including 40-year mortgages. These are still legal, but won’t qualify under the safe-harbor provisions. Lenders can’t use this trick to circumvent DTI rules.

Interest-only and negative amortizing loans won’t qualify.

By 2005 – the height of the real estate frenzy, nearly a quarter of all mortgages issued were “interest-only” loans. That is, you only paid the interest, and the entire principal came due in, say, five years. The number of interest-only mortgages held by Freddie Mac increased over 500 percent, from $25 billion in 2005 to $159 billion in 2007. One South-Florida mortgage broker told me in 2006 that over half of her business at the time was now in interest-only paper (we both agreed that this would not end well).

The assumption was, at that time, that it would be easy to refinance into a highly-appreciated property in five years, and you could pay off the principal at your leisure.

The ‘highly-appreciated’ part of that equation, of course, turned out to be a doozy.

Interest-only loans will no longer be qualified mortgages. The same applies to ‘negative-amortizing’ loans. That is, loans where your payments are actually less than the interest, so that your outstanding balance actually increases over the life of the loan.

The new regs also disqualify ‘balloon payment’ loans – part and parcel of the interest-only and negative amortization loan world – except in limited cases in rural areas where such loans are already routine.

Curiously, the regs provide an incentive to consumers to get an interest-only loan: Since these loans won’t be “qualified mortgages,” the borrower’s right to sue is preserved. But lenders have a corresponding disincentive to provide them. As a result, costs on these kinds of loans, as well as the now-rare 40-year mortgage, will likely go up. After all, lenders will expect to be compensated for the increased risk of a non-qualified mortgage.

Qualified mortgages can have points and fees equal to not more than 3 percent of the loan.

This won’t be a game-changer since most loans already have points and fees below this level. Its effects will mostly be felt among mortgage brokers and in the subprime world, where borrowers have fewer options. Three percent has been a common ceiling for quite a while now, anyway.

Qualified mortgages can be priced no higher than 1.5 percent over prime.

This can be tricky, because it smacks of price controls, and price controls almost always fail. Almost by definition, this rule will impact the subprime market, and have a disparate impact on borrowers with low credit scores.

Moreover, the price cap spells trouble if yield curves steepen. If yields on comparable non-mortgage debt increase and offer a sweeter profit to lenders than the mortgage markets, capital will flee subprime and alt-A mortgage pools. That may be a ways off, but the law of unintended consequences is a constant threat.  

What’s notable about the regulation, however, is its restraint. The regulators were trying to strike a balance between protecting consumers from predatory lending to uneducated, unsophisticated consumers, and shutting off the flow of credit to the housing sector.

The Ability to Pay Rule does not establish any minimum down payment nor any minimum credit score. It’s still left up to lenders to determine that for themselves.

The rule also leaves open the window for VA lenders to lend qualified mortgages and FHA lenders to lend with just 3.5 percent down without running afoul of qualified mortgage rules.

The regulators also exempt VA lenders and Fannie and Freddie from the rules for up to seven years. Because these are such a big part of the mortgage market, the new rules are only going to take hold gradually. This is by design, since the CFPB did not want to cause a sudden disruption in the still-fragile housing market.

 

 

Mortgage image courtesy of Shutterstock.