Home > Securitization > Residential Mortgage Backed Securities > New era of lender liability: New mortgage lending rule requires lenders to assess borrower’s ability to repay


by Vinod Kothari


The new truth-in-lending rule, promulgated by Consumer Financial Protection Bureau, which takes effect for mortgages originated from 10th Jan 2014, requires lenders to make a “reasonable, good faith determination” of the borrower’s ability to repay a mortgage loan, unless the mortgage loan falls in “qualified mortgage” category. The new rule is an amendment in Rule Z under the Truth in Lending Act, implemented pursuant to sections 1411 and 1412 of the Dodd Frank Act. The final rule also implements section 1414 of the Dodd-Frank Act, which limits prepayment penalties.

The lender will be required to make an assessment of the borrower’s ability to repay (ATR) based on objective assessment of 8 factors, viz:

  • The borrower's current income or assets
  • The borrower's current employment status, if income used is from employment
  • Monthly principal and interest (P&I) payments (in case of adjustable rate mortgages, fully indexed)
  • Monthly P&I of any simultaneous second lien mortgage loan
  • Monthly payments of other mortgage related obligations (taxes and insurance [T&I], condo assessments, etc.)
  • Current debt obligations
  • Monthly debt-to-income (DTI) or residual income (no specific limits); and
  • Credit history.

These ability-to-repay requirements apply to any consumer credit transaction secured by a dwelling, except a home equity line of credit subject to 12 C.F.R. § 226.5b (i.e., an open-end credit plan), a timeshare plan, a reverse mortgage, or any temporary or bridge loan with a term of 12 months or less.

Dodd-Frank called for the creation of a new category of loans (i.e., qualified mortgages) that would be presumed to comply with the ability-to-pay requirements. The Final Rule defines "qualified mortgages" as those that, in addition to meeting the above-identified ability-to-repay requirements, satisfy the following criteria: 1) the loan does not feature negative amortization, interest-only payments, balloon payments, or a term exceeding 30 years; 2) the total points and fees do not exceed 3% of the total loan amount for loans exceeding $100,000 (with a provision for a sliding scale of acceptable caps on fees for lesser loan amounts); 3) the borrower's income or assets are verified and documented; and 4) the borrower's DTI ratio is not greater than 43%.        

According to the CFPB's extensive preamble to the Final Rule, the rule distinguishes between two types of qualified mortgages based on a mortgage's annual percentage rate relative to the average prime offer rate for comparable transactions. For loans that exceed the average prime offer rate by a specified amount—loans denominated as "higher-priced mortgage loans"—the rule provides a rebuttable presumption that the creditor has satisfied the ability-to-repay requirements, but a consumer may rebut that presumption under carefully defined circumstances. The consumer must demonstrate that, at the time the loan was made, the consumer did not, in fact, have sufficient income or assets (other than the value of the dwelling securing the loan), after paying his or her mortgage and other debts, to be able to meet his or her other living expenses of which the creditor was aware.

For all other qualified loans (i.e., loans that are not higher priced), the Final Rule provides a safe harbor—a conclusive presumption that the creditor has satisfied all of the ability-to-repay requirements—once the creditor proves that it has, in fact, made a qualified mortgage.

DTI Ratio Cap

The Final Rule establishes a maximum DTI ratio for all qualified mortgages, requiring that a borrower's DTI ratio be less than or equal to 43%. This number is to be calculated based on the highest interest rate that will apply in the first five years of the loan as opposed to any lower introductory interest rate. Otherwise, qualifying loans that are eligible to be purchased, guaranteed, or insured by the Department of Housing and Urban Development, the Department of Veterans Affairs, the Department of Agriculture, the Rural Housing Service, or the Federal National Mortgage Associate or Federal Home Loan Mortgage Corporate, while operating under federal conservatorship, are temporarily exempt from this requirement. This exemption expires at the earlier of 1) seven years after the Final Rule's effective date or 2) the issuance by the federal agencies of their own qualified mortgage rules.

Other Provisions

The Final Rule implements Dodd-Frank's prohibition of prepayment penalties except on certain fixed-rate qualifying mortgages where the penalties satisfy strict size and duration limits and where the creditor has offered the borrower an alternative loan without penalties. The Final Rule also sets a uniform period during which creditors must retain records evidencing compliance with the ability-to-repay and prepayment penalty provisions.

What the Final Rule Means for Lenders

  • Lenders may no longer base ability-to-repay decisions on teaser rates, rather they must base all lending decisions on the principal and interest over the life of the mortgage.
  • Interest-only loans or loans with balloon payments cannot meet the qualified-mortgage standards.
  • Most qualified mortgages will have a 3% cap on the amount of fees and origination costs that lenders can charge (inclusive of title services and legal settlement charges).
  • Although lenders are free to make loans that do not meet the qualified-mortgage criteria, these lenders may face difficulty reselling them on the secondary market and will not qualify for any safe-harbor protections.
  • Loans made by smaller lenders in rural and underserved communities must consider the above-mentioned DTI ratio requirement as a part of their underwriting requirements but do not have to comply with the 43% ratio.
  • Borrowers are not required to make a minimum down payment or meet minimum credit score requirements to obtain a qualified mortgage.

Finally, the final rule requires creditors to retain evidence of compliance with the rule for three years after a covered loan is consummated. If the lender fails to comply with the test, the lender may face penalties, as well as defences in any legal action the lender may take for recovery or foreclosure.

Interestingly, the obligations percolate down even to an assignee of the mortgages – hence, in case of securitization, even a securitization trust may be affected by the lender’s breaches.

While there are tons of materials explaining various Dodd Frank rules, a very well written article by Standard and Poor’s explaining the ATR rule is here. A CFPB page explaining the ATR rule, effective date, etc is here.