Last week, the Consumer Financial Protection Bureau (CFPB) issued its final Ability-to-Repay Rule (the Rule). The CFPB is also seeking comments on a concurrent proposal that would modify the ability-to-repay rule, which it intends to finalize this spring. The Rule, including any of the concurrent proposal’s changes that are finalized, will take effect on January 10, 2014. 

The Dodd-Frank Wall Street Reform and Consumer Protections Act amended the Truth in Lending Act to require that creditors make a reasonable and good faith determination of a borrower’s ability-to-repay a residential mortgage. The Truth in Lending Act’s Regulation Z currently requires an ability-to-repay determination to be made on higher-priced mortgages, but the Dodd-Frank amendment, to be implemented by the Rule, extends the requirement to all closed-end residential mortgage loans. 

The Rule contains the following key elements: 

Underwriting Factors 

The Rule describes certain minimum requirements for creditors making ability-to-repay determinations, but does not dictate that they follow particular underwriting models. At a minimum, creditors generally must consider eight underwriting factors:

1. current or reasonably expected income or assets 
2. current employment status 
3. the monthly payment on the covered transaction 
4. the monthly payment on any simultaneous loan 
5. the monthly payment for mortgage-related obligations 
6. current debt obligations, alimony, and child support 
7. the monthly debt-to-income ratio or residual income 
8. credit history

Creditors must use reasonably reliable third-party records to verify the information they use to evaluate the factors. 

Additionally, the Rule provides guidance on the application of the factors under the statute. For example, monthly payments must be calculated by assuming that the loan will be repaid in substantially equal monthly installments during the loan term. Monthly payments for adjustable rate mortgages must be calculated using the fully indexed rate or an introductory rate, whichever is higher. For loans with balloon payments, interest-only payments or negative amortization, special payment calculation rules apply. 

The Rule also provides special provisions to encourage creditors to refinance “non-standard mortgages,” (i.e., risky mortgages which can lead to payment shock that can result in default) into a more stable loan with fixed rates for at least five years that reduce consumers’ monthly payments. Creditors providing this type of refinancing will not be required to undertake the full underwriting process. 

The Qualified Mortgage 

Under the Dodd-Frank Act, “qualified mortgages” are entitled to a presumption that the creditor making the loan complied with the ability-to-repay requirements. The Act, however, did not specify whether the presumption of compliance is conclusive (i.e., creates a safe harbor) or is rebuttable. The final Rule clarifies that if the qualified mortgage is a higher-priced mortgage, as defined in Regulation Z, the presumption of compliance will be rebuttable. 

The Rule strengthens the requirements needed for a subprime loan to qualify for the rebuttable presumption and defines with more particularity the proper grounds for rebuttal. Specifically, it provides that consumers may show a violation with regard to subprime qualified mortgages by showing that, at the time the loan was originated, the consumer’s income and debt obligations left insufficient residual income or assets to meet living expenses. 

With respect to prime loans, the Rule applies the new ability-to-repay requirements but creates a strong presumption for those prime loans that constitute qualified mortgages. Thus, if a prime loan satisfies the qualified mortgage criteria described below, it will be conclusively presumed that the creditor made a good faith and reasonable determination of the consumer’s ability to repay. 

General Requirements for Qualified Mortgages 

The Rule implements statutory criteria from Dodd-Frank, which prohibit loans with negative amortization, interest-only payments, balloon payments or a term in excess of 30 years from being qualified mortgages. Also, a loan cannot be a qualified mortgage if the points and fees paid by the consumer exceed three percent of the total loan amount, although certain “bona-fide discount points” are excluded for prime loans. The Rule further provides that in order for the loan to be a qualified mortgage, the borrower’s total (or “back-end”) debt-to-income ratio must be less than or equal to 43 percent. For purposes of underwriting, monthly payments must be calculated based on the highest payment that will apply in the first five years of the loan. 

The CFPB, recognizing the “fragile state of the mortgage market,” has established within the Rule, a temporary second category of qualified mortgages that have more flexible underwriting requirements. To fit into this category, a loan must satisfy the general product features for a qualified mortgage, and must be eligible either:

1. to be purchased by Fannie Mae or Freddie Mac while operating under Federal conservatorship or receivership 
2. guaranteed or insured by the Department of Housing and Urban Development, Department of Veterans Affairs or Department of Agriculture or Rural Housing Services.

This temporary category will phase out over time as the various Federal agencies issue their own qualified mortgage rules and the GSE conservatorship ends, or within seven years, whichever occurs first. 

Balloon Qualified Mortgages 

Pursuant to Dodd-Frank authority, the CFPB has proposed to allow certain balloon-payment mortgages to be treated as qualified mortgages if they are originated and held in portfolio by small creditors operating predominantly in rural or underserved areas. Such loans must have a term of at least five years, a fixed-interest rate and meet certain basic underwriting standards. Debt-to-income ratios must be considered but will not be subject to the 43 percent general requirement. Additionally, only those creditors that originate at least 50 percent of their first-lien mortgages in rural or underserved counties (as designated by the CFPB), have less than $2 billion in assets and, along with their affiliates, originate not more than 500 first-lien mortgages per year will be eligible to make rural balloon-payment qualified mortgages. Creditors must hold the loans on their portfolios for three years in order to maintain their “qualified mortgage” status. 

Other Final Rule Provisions 

The Rule also implements Dodd-Frank Act provisions that prohibit prepayment penalties except for certain fixed-rate, qualified mortgages where the penalties satisfy certain restrictions and the creditor has offered the consumer an alternative loan without such penalties. To match with certain statutory changes, the Rule also lengthens the time creditors must retain records that evidence compliance with the ability-to-repay and prepayment penalty provisions to three years and prohibits evasion of the Rule by structuring a closed-end extension of credit that does not meet the definition of open-end credit as an open-end plan. 

Concurrent Proposal 

The concurrent proposal issued with the Ability-to-Repay Rule specifically seeks comment on whether it would be appropriate to exempt designated non-profit lenders, homeownership stabilization programs and certain Federal agency and GSE refinancing programs from the ability-to-repay requirements. The CFPB is also seeking comment on whether loans without a balloon payment feature that are originated and held in portfolio by small creditors should constitute another category of qualified mortgages. The request asks whether to increase the threshold separating safe harbor and rebuttable presumption qualified mortgages for both rural balloon-payment qualified mortgages and small portfolio qualified mortgages to 3.5 percentage points above the average prime offer rate for first-lien loans. 

The full text of the Final Rule can be found here. 

Although the effective date of the new Ability-to-Repay Rule is one year away, now is the time to begin planning for its implementation.