The Ability To Repay Rule: What it means for lenders?

This short note analyses the basis and possible effects of most important piece of mortgage regulation to come into effect in January 2014 which the Ability-To-Repay Rule. The Consumer Financial Protection Bureau amended Regulation Z, which implements the Truth in Lending Act (TILA). Regulation Z currently prohibits a creditor from making a higher-priced mortgage loan without regard to the consumer’s ability to repay the loan. The final rule implements sections 1411 and 1412 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). A lender obligation under the new rule has to “make a reasonable and good faith determination based on verified and documented information that the consumer has a reasonable ability to repay the loan according to its terms.”

Basis of the rule

The new rule on ability-to-repay reflects the notion that the blame for the housing market failure should be attributed to lenders only. That is to say that the lax lending standards alone led consumers into home mortgages they could not afford. However, logically this is not possible. If lenders and borrowers believed that house prices would continue to rise rapidly for the foreseeable future, then why shouldn’t borrowers ahead and buy prime houses? Rising house prices generate large capital gains for home purchasers. They also raise the value of the collateral backing mortgages, and thus reduce or eliminate credit loses for lenders.

The legislation has failed to look through the fact that the losses to borrowers were across the board and not limited to subprime borrowers only. Borrowers with mortgages that carried a fixed-interest rate had very similar problems to borrowers with hybrid mortgages. Borrowers who obtained a subprime mortgage when they bought a home had the same problems in 2006 and 2007 as those who refinanced their existing mortgages to extract cash. Borrowers who provided full documentation and no documentation followed the same pattern.

Thus under the ability-to-repay regime, the accountability for loans has been shifted from borrowers to lenders. This is based on the premise that consumers are incapable of acting in their own interests and making sound financial decisions and that the government should intervene by passing a law that only protects them.

The lawmakers have justified this paradigm shift by citing statistics on the wave of defaults and foreclosures during the housing crash. While many homeowners did incur terrible losses, most were not victims of predatory lending or fraud. The hard truth is that most of them bet on rising home values and lost when the market collapsed. They made financial decisions which did not play out as they had expected.

Likely Consequences

First, this ability-to-repay rule is not just a procedural or compliance rule because the Dodd Frank Act has given the borrower a new right: the right to sue the lender for wrongly gauging the borrower’s financial health before sanctioning a loan. Under the new regime, a borrower may sue a lender within 3 years of an alleged violation, such as improperly documenting income or assets, or incorrectly calculating the borrower’s financial obligations. If the court orders in favour of the borrower, then the borrower can recover damages not only equal to the sum of all finance charges but also other costs such as fees paid.

Second, a defaulting borrower can now use the rule as defence against the threat of foreclosure. And even if the original lender sold the mortgage or assigned it to an SPV, the SPV will get dragged into litigation. If successful, the borrower may recover all mortgage finance charges and fees paid in addition to actual damages, damages in an individual action or class action and court fees. This will reduce borrowers’ legal costs and thus increase the incentive to claim a violation of the ability-to-repay requirement in the event mortgage payments become burdensome.

The consequence of this new cause of action will be more litigation and less credit availability for the lenders. Even if a lender ultimately prevails in a legal challenge, it will not be spared the costs of litigation. According to data submitted to the CFPB, the average litigation cost to secure a motion to dismiss runs an estimated $26,000, summary judgment is $84,000, and trial is $155,000.[1] Further, there is a new prohibition on pre-dispute arbitration which will drag such matters to the court that would have otherwise been resolved by arbitration.

Although there are specific rules for computing some asset and debt factors, the CFPB is allowing some flexibility to the borrowers. This however may lead to more trouble because while lenders will surely enjoy some independence in designing ability-to-repay procedures, there will be no fixed compliance standard to follow, which will definitely bring about many unintended and arbitrary enforcement actions. There are no definitive tests that can be prescribed to determine whether a creditor, in considering those factors, arrived at a belief in the consumer’s ability to repay which were both reasonable and in good faith. Further the Congress has avoided accountability by delegating its legislative authority to CFPB. Thus whatever rule the CFPB will determine will be final.

Even CFPB acknowledge that the new rules will raise the costs and risks of mortgage lending. Creditors must reconfigure policies and procedures, reprogram loan origination systems, and retrain personnel, thereby increasing the costs of underwriting loans. The threat of litigation will breed greater caution among lenders and thus further restrict the availability of credit. The impact will be particularly hard on smaller community banks that lack the capacity to increase their compliance staff or to hire consultants. Many have already started to exit the housing market.

Shambo Dey







[1] “Consumer Financial Protection Bureau, Ability-to-Repay and Qualified Mortgage Standards Under the Truth in Lending Act,” Federal Register.