Lenders made millions of mortgages during the decade of the 2000s, some of which were not rigorously underwritten, and for some of which the borrowers had no hope of repaying. As the loans went into default, lenders' losses mounted and borrowers' woes increased. The mortgage market's collapse led to the second greatest economic recession in the last 100 years and nearly brought the United States' economy to its knees.
To remedy this situation, Congress and various federal agencies required lenders to assess a consumer's ability to repay a home loan before the creditor could extend the consumer the credit. To encourage responsible lending, Congress provided for penalties where a loan was made to a borrower who did not have the ability to repay it fully. Congress also permitted the regulators to create a "safe harbor" for creditors, where it would be presumed that the borrower had the ability to repay a mortgage loan.
On January 10, 2013, the Consumer Financial Protection Bureau (Bureau) released its final Ability-to-Repay and Qualified Mortgage Rule, effective January 10, 2014. This article will look at that rule by first exploring the background and financial situation that led to the release of the rule, Congress' statutory enactments permitting the rule, and the final rule itself.
Background
In the early part of the last decade, as housing prices rocketed skyward, lenders began introducing products that permitted borrowers to take advantage of their increasing equity. Lenders moved away from the fully-amortizing, fixed-rate, 30-year loan, and offered hybrid adjustable-rate mortgages where the initial interest rate was set at a below-market rate for a fixed period, such as two, three, five, or seven years. Lenders offered fully adjustable rate loans, where the interest rate was adjusted on a monthly or yearly basis. As the demand for loans increased, both by borrowers and investors, lenders offered loans with an interest-only payment, deferring the repayment of principal for a period of years. This permitted borrowers to obtain larger loans than could be afforded if the loans had to be repaid in equal payments of principal and interest over 30 years. Finally, the industry offered option ARM loans, where a borrower could choose to repay a portion of the interest owed, adding the remainder to an increasing principal balance.
To facilitate these loans, lenders relaxed their underwriting standards. Low-document and no-document loans proliferated. Borrowers could state their income, without offering any verification of it, and lenders would rely on the representations. Lenders would check borrowers' credit and the value of the property, and little else. As long as the property value elevator rode upward, lenders made the loans, borrowers obtained loans, and investors bought loans.
Many borrowers took advantage of these loans, obtaining cash-out refinances. The cash-out portion may not have been used to improve the value of the property, and was often lost to repayment of other (overextended) debts, or to fund new purchases of vacations, impermanent assets, or consumables. In addition, with the advent of easier-to-obtain loans, new borrowers entered the housing market and became first-time homeowners for a small or no down payment. These borrowers often obtained loans with adjustable rate features or limited principal repayment that exposed the market to risk as payments adjusted or property values declined.
In the middle to late 2000s, the housing market slowed and reversed, and many borrowers were unable to repay their loans. As loans went into default and foreclosures increased, lenders and servicers were overwhelmed, and investors began to take losses. With the collapse of the housing market, America, and the world, entered the most serious recession since the Great Depression.
Reaction to the Housing Crisis - Ability to Repay Consideration
In 2008, the Federal Reserve Board (Board) adopted a rule under the Truth in Lending Act which prohibited creditors from making "higher-price" mortgage loans without assessing consumers' ability to repay the loans. Under the Board's rule, a creditor is presumed to have complied with the ability-to-repay requirement if the creditor followed specified underwriting practices.
In 2010, when Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Sections 1411 and 1412 required lenders to assess consumers' ability to repay all home loans before extending credit and provided that the regulators could create a safe harbor and presumption of compliance with the ability-to-repay requirement for "qualified mortgages." Congress set forth the requirements in a new section of the Truth in Lending Act, Section 129C (link here), and permitted rulemaking to interpret the act and provide guidance to the industry and consumers.
The Bureau conducted extensive research and analysis on this issue. It sought public comment on new data and information, and the Bureau met with stakeholders on all sides in formulating the rule. On January 10, 2013, the Bureau released the final rule. (See "Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z)" at www.consumerfinance.gov. See also Ability-to-Repay and Qualified Mortgage Standards under the Truth in Lending Act, Final Rule, 78 Fed. Reg. 6408 (January 30, 2013), to be codified at 12 C.F.R. ยง 1026.) The Bureau stated that the rule protects consumers from risky practices that helped cause the mortgage crisis. It helps ensure that responsible consumers obtain responsible loans and that creditors can extend credit responsibly, without worrying about competition from unscrupulous lenders.
Under the statute, the ability-to-repay requirements are effective as of January 21, 2013. The final rule delays the implementation of the ability-to-repay requirements until January 10, 2014. If a successful challenge is mounted to the recess appointment of Richard Cordray as director of the Bureau, the ability-to-repay provisions are effective immediately. It is unknown whether they will have a retroactive effect.
Ability-to-Repay Rule
The Ability-to-Repay Rule, Regulation Z Section 1026.43, requires that a creditor make a "reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms." The creditor must follow underwriting requirements and verify the information by using reasonably relied upon third-party records. The rule applies to all residential mortgages including purchase loans, refinances, home equity loans, first liens, and subordinate liens. In short, if the creditor is making a loan secured by a principal residence, second or vacation home, condominium, or mobile or manufactured home, the creditor must verify the borrowers' ability to repay the loan. The section does not apply to commercial or business loans, even if secured by a personal dwelling. It also does not apply to loans for timeshares, reverse mortgages, loan modifications, and temporary bridge loans.
The creditor must consider and evaluate at least the following eight factors:
Current or reasonably expected income or assets. The creditor may consider borrowers' assets and income that borrowers will use to repay the loan. The creditor may not consider the value of the secured property, including any equity in the dwelling. Because of seasonal work, or other factors that result in variable income, the creditor may consider current income and "reasonably" expected income. A creditor may also consider a joint applicant's income and assets.
Current employment status. The creditor must consider borrowers' current employment status to the extent that the creditor relies on the employment income to repay the loan. If borrowers' intend to repay the loan with investment income, employment need not be considered.
Monthly payments on the covered transaction. The monthly payment obligation is based on the "full" payment. The payment must be considered on a monthly basis, and be at the fully adjusted indexed rate or the introductory rate, whichever is higher. In short, teaser rates and other "low" starting rates are not to be considered in the ability-to-repay analysis.
Monthly payments on a simultaneous loan. The creditor must consider the "full" monthly payments on any simultaneous loan that the creditor knows or has reason to know will be made on or before consummation when secured by the same dwelling. This includes piggy-back loans, concurrent loans, and open-ended home equity loans, even if made by another creditor. The rule applies to purchases and refinances.
Monthly payments for mortgage-related obligations. The creditor must consider payments for mortgage-related obligations, according to the loan's terms, and all applicable taxes, hazard insurance, mortgage guarantee insurance, assessments, ground lease payments, and special assessments (if known). The creditor must consider these amounts whether or not an escrow is established. Where these charges are paid on an annual or periodic basis, they are to be calculated as if paid monthly. However, where the charge is a onetime, up-front fee, it need not be considered in the ability-to-repay calculation.
Current debt obligations, alimony, and child support. The creditor must consider borrowers' other debt obligations that are actually owed. Each applicant's obligations are to be evaluated, but the creditor does not need to consider other obligations of sureties or guarantors. Creditors are given significant flexibility in this area and may use reasonable means to consider other debt obligations.
Monthly debt-to-income ratio or residual income. The rule gives the creditor flexibility in defining "income" and "debt" based on governmental and non-governmental underwriting standards. The rule also gives the creditor flexibility in evaluating the appropriate debt-to-income ratio in light of residual income. For example, where the debt-to-income ratio is high and the borrowers have a large income, the borrowers should have sufficient remaining income to satisfy living expenses and therefore justify the loan. The determination is subject to a reasonable and good faith standard.
Credit history. A creditor must consider borrowers' credit histories, but does not have to review a specific credit report or minimum credit score. Creditors may consider factors such as the number and age of credit lines, payment history, and any judgments, collections, or bankruptcies. The creditors must review borrowers' credit histories and give various aspects as much or little weight as is appropriate to reach a reasonable, good faith determination of borrowers' ability to repay the loan.
Creditors will typically use third-party records (not prepared by the consumer, creditor, mortgage broker, or any of their agents) to make a reasonable and good faith determination, based on verified and documented information, that a consumer has a reasonable ability to repay the mortgage loan. The rule requires that the creditor retain evidence of the ability to repay for three years. However, because of possible challenges by borrowers to the ability-to-repay determination, it is recommended that creditors and their successors maintain these records for the life of the loan.
The Ability-to-Repay Rule does not apply to every loan. Principally, the rule does not apply where a
non-standard mortgage (such as an adjustable rate loan, interest-only loan, or negative amortization loan) is refinanced into a standard mortgage, where the current creditor provides the refinance, the new payment will be materially (10 percent) lower, and most of the previous payments were timely. However, the ability-to-repay analysis implicitly applies to the new loan.
Qualified Mortgages
The Dodd Frank Act provided that "qualified mortgages" are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. The Bureau's rule establishes a safe harbor and creates a conclusive presumption for loans that meet certain criteria and are not high-priced loans that the creditor made a good faith and reasonable determination of the consumer's ability to repay. Where the loan satisfies the requirements of a qualified mortgage and is a high-priced loan, there is a rebuttable presumption that the creditor complied with the ability-to-repay requirement. Borrowers may overcome the presumption when they can show that after making all mortgage related payments there is insufficient income left over to meet living expenses. The longer it takes for borrowers to default, the more difficult it is to overcome the presumption.
A qualified mortgage includes the following criteria:
Regular substantially equal periodic payments. This does not include negative amortization loans, interest only payments, and balloon payments. If the loan does not require monthly payments, the payments are to be calculated as if paid monthly.
Term is 30 years or less.
Total points and fees to not exceed 3 percent of the loan amount. Points and fees are broadly interpreted. The 3 percent cap is adjusted as the loan balance falls below $100,000. Points and fees include all items in the finance charge as defined in the Truth in Lending Act, other than interest. The points and fees include loan originator compensation paid by the consumer or creditor, as known at the time the interest rate is set, if attributable to the transaction, whether paid to the individual loan officer or a broker. The points and fees include charges paid to the creditor, originator, or affiliate, even if the same fees would not be included if charged by an independent third party. For example, title charges by an affiliated title company are included in the 3 percent calculation, but similar charges by an independent title company are not. The points and fees included other charges as detailed by the rule. The loan amount is the amount stated in the promissory note.
Monthly payment calculated based on the highest expected payment in the first five years. The creditor must underwrite the loan based on a fully amortized payment schedule taking into account the highest adjustment of any loan payment, and all other mortgage-related payments, including taxes and insurance, whether or not impounded by the creditor.
Consider current and reasonably expected income and expenses. This includes debt obligations, alimony, and child support. The income and expenses must be verified and documented, as discussed above. This eliminates low-document and no-document loans from being qualified mortgages.
Debt-to-income ratio does not exceed 43 percent. The debt includes all mortgage-related expenses, and simultaneous mortgage-related expenses that the creditor knows or has reason to know.
If these criteria are met and the loan is underwritten with good faith and reasonable reliance on verified third-party provided documentation, then the loan is a qualified mortgage entitled to a conclusive presumption that the loan meets the ability-to-pay requirements.
Alternative Qualified Mortgages
The Bureau established a second, temporary class of qualified mortgages based on the belief that certain consumers can afford loans with a higher debt-to-income ratio of 43 percent based on their particular circumstances. In addition, the temporary class of qualified mortgages may help overcome any initial reluctance of creditors to make loans that might not be qualified mortgages. These loans may be underwritten with more flexibility, but still require a reasonable and good faith belief in borrowers' ability to repay the loans.
These alternative qualified mortgage loans must satisfy the general product feature prerequisites for a qualified mortgage and also satisfy the underwriting requirements of, and are eligible to be purchased, guaranteed or insured by (1) the GSEs while they operate under federal conservatorship or receivership or (2) the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service. This temporary class will phase out as each agency issues its own qualified mortgage rules, or the GSE conservatorship ends, or seven years elapse.
Note that the rule does not define how the eligibility determination is made if the GSEs or federal agency does not actually purchase, guarantee, or insure the loan. Similarly, in light of the current state of repurchase litigation, even if the loan is purchased, guaranteed, or insured, it is unknown if that determination creates a qualified mortgage "presumption" that is conclusive or rebuttable.
Failure to Comply with Ability-to-Repay
A creditor must properly determine whether borrowers have the ability to repay their loans. Where a creditor does not act properly, the Bureau retains the ability to issue cease and desist orders, or impose civil monetary penalties.
The rule provides a private right of action to borrowers. They may seek actual damages, statutory damages, costs, and attorneys' fees, and special damages equal to the finance charges and fees incurred. In short, where the creditor does not properly assess borrowers' ability to repay loans, borrowers must repay the principal amount of the loan, less damages, and could end up with a "free" loan. Borrowers may also seek damages in class action litigation and individual cases. While current law provides for a one-year statute of limitation on damage actions, borrowers have three years to bring their ability-to-repay damage claims.
Borrowers may also assert the ability-to-repay defense in response to a foreclosure action and seek recoupment or set-off. The three-year statute of limitation does not apply, but borrowers are limited to three years of finance charges and fees as special damages. Assignees are liable for the errors of the original creditor.
Conclusion
Creditors must assess borrowers' ability to repay a loan based on verifiable information. Creditors must act in a good faith and reasonable manner to determine whether borrowers can afford the loan(s) offered. To avoid liability under a faulty ability-to-pay determination, creditors may rely on the safe harbor of the qualified mortgage conclusive presumption. Qualified mortgages must be fully underwritten, at the maximum adjusted payment, based on verifiable information provided by third parties, to a high level of specification, even though the rule provides the creditor with discretion to make its determination. It is unknown what types of loans will be offered to borrowers and whether the loans will be purchased in the secondary market. However, it is expected that in the initial term, most residential mortgages will be low cost, fixed-rate loans, issued to very credit-worthy borrowers who meet all lending criteria. As GSEs and other agencies agree to purchase, guarantee or insure loans, the pool of available loans will expand, helping the Bureau meet its goal of ensuring that responsible consumers obtain responsible loans and that creditors extend credit responsibly, without worrying about competition from unscrupulous lenders.