Compliance Bulletin

Analysis of Dodd-Frank Act: Determining Ability to Repay
July 19, 2010

In the previous Bulletin on the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Reform Bill”), we referred to two key definitions used in Title XIV.

 Title XIV is the “Mortgage Reform and Anti-Predatory Lending Act” (“Mortgage Act”), which encompasses several provisions intended to enhance consumer protections in mortgage lending. For your convenience, those definitions are restated here, as they pertain to the subject of this Bulletin—determining a consumer’s ability to repay a residential mortgage loan.

Key Definitions

A mortgage originator is a person who, for compensation or gain does any of the following: (i) take a residential mortgage loan application; (ii) assists a consumer in obtaining or applying for such a loan (inclusive of advising on loan terms, preparing loan packages, or collecting information); or (iii) offers or negotiates the terms of the loan. A residential mortgage loan is a consumer credit transaction that is secured by a mortgage, deed of trust, or other equivalent consensual security interest on a dwelling (or on residential real property that includes a dwelling). Please the previous Bulletin for an analysis of these terms.

Determining Ability To Repay

New Section 129C is added to TILA requiring creditors, when making a residential mortgage loan, to make a “reasonable and good faith” determination of the borrower’s ability to repay (including taxes, insurance, and assessments) based on verified and documented information, and taking into consideration other loans securing the same dwelling. The creditor must consider the consumer’s credit history, current income, expected income, current obligations, debt-to-income ratio or “residual income,” employment status, and other financial resources other than the consumer’s equity in the subject property. Ability to repay must be based on a payment schedule that fully amortizes the loan.

Income must be verified by reviewing the consumer’s W–2, tax returns, payroll receipts, bank records, or other relevant third party documents. As a check against fraud, income history must be checked against IRS transcripts of tax returns or by some other method subject to Federal Reserve Board (“Board”) rulemaking.

With respect to loans made, guaranteed, or insured by certain federal departments or agencies, the government entities have the discretion to allow an exemption from the verification requirement for refinancings if: (1) the consumer is not 30 days or more past due on the existing mortgage; (2) the outstanding principal balance is not increased, except for allowable fees and charges; (3) points and fees (other than bona fide third-party charges not retained by the originator, creditor, or their affiliates) do not exceed 3% of the loan amount; (4) the interest rate is lower than on the original loan, unless the refinancing is from an adjustable rate loan to a fixed rate loan, subject to guidelines of the applicable government department or agency); (5) the loan will fully amortize, subject to new regulations; (6) there is no balloon payment; and (7) both the existing and refinancing loans satisfy the requirements of the applicable department or agency.

Special rules apply to so-called “non-standard” loans. For purposes of determining a borrower’s ability to repay, if a variable-rate loan allows or requires deferral of principal or interest, the creditor must use a fully amortizing repayment schedule. For loans that permit or require payment of interest only, the payment amount is the amount required to amortize the loan by its final maturity. In either instance, any negative amortization must be taken into account.

When calculating the monthly payment, the creditor is to assume that (1) the loan proceeds are fully disbursed at closing; (2) there will be substantially equal monthly payments that amortize principal and interest over the term of the loan; and (3) the interest rate over the term of the loan is a fixed rate equal to the fully indexed rate at origination without considering the introductory rate.

For loans that are not repaid with equal monthly payments that completely amortize (including loans with balloon payment), the calculation under (2) above must be made in accordance with Board regulations if the loan has an APR no more than 1.5% higher than the average prime offer rate for a comparable transaction (for a first lien loan) or no more than 3.5% higher (for a subordinate lien loan), or in accordance with note if the respective APRs are higher than these thresholds.

The Act favors refinancings of “hybrid” loans (not defined) into “standard” loans by the same creditor. In such instances, if the monthly payment on the new loan would be reduced and there has been no delinquency on the existing loan, the creditor may take into consideration for purposes of determining ability to repay the borrower’s good standing. If the new loan would prevent a likely default when the original mortgage resets, the creditor may treat such a concern as a higher priority for purposes of underwriting. It may also offer rate discounts and other favorable terms that would be available to new customers with high credit ratings.

The requirement to determine ability to repay does not apply to reverse mortgages or temporary or bridge loans with a term of 12 months or less (including a loan to purchase a new dwelling where the consumer plans to sell a different dwelling within 12 months). If documented income, including income from a small business, is a repayment source for a residential mortgage loan, a creditor may consider the seasonality and irregularity of such income when underwriting scheduling payments.

Safe Harbor. The provision requiring verification of ability to repay includes a rather complicated safe harbor in the event that a creditor or an assignee is subject to liability. They may assert a presumption of compliance if the loan is a “qualified mortgage.” A qualified mortgage is one that meets each of the following criteria:

(i) the periodic payments do not result in an increase or deferral of principal payments;
(ii) there are no balloon payments (i.e., where a scheduled payment is more than twice as large as the average of earlier scheduled payments, except as discussed below);
(iii) the income and financial resources relied upon are verified and documented;
(iv) for fixed rate loans, the underwriting is based on a payment schedule that fully amortizes the loan, inclusive of taxes, insurance, and assessments;
(v) for adjustable rate loans, the underwriting is based on the maximum rate permitted during the first 5 years and full amortization;
(vi) the loan complies with Board guidelines and regulations relating to debt load;
(vii) total points and fees do not exceed 3% of the loan amount;
(viii) the loan term does not exceed 30 years (except as otherwise permitted, such as in high-cost areas); and
(ix) as to reverse mortgages (except as exempted) the standards for a qualified mortgage are satisfied, as established by the Board by regulation (see below).

The Board has the discretion to modify the criteria for a qualified mortgage by regulation. In addition, the departments and agencies indicated in footnote 1 of this Bulletin may write regulations, in consultation with the Board, defining what is a qualified mortgage with respect to the loans that they insure, guarantee, or administer, as applicable.

Specifically, the Board has the discretion to develop a regulation to include balloon loans within the definition of “qualified mortgage.” Any regulation that the Board writes must provide that:

(i) the loan otherwise meets the criteria for a qualified mortgage (except the provisions requiring full amortization and barring deferral of principal);
(ii) the creditor determines that the consumer is able to make all scheduled payments, except the balloon payment, out of income or assets other than the collateral;
(iii) the underwriting is based on a payment schedule that fully amortizes the loan over not more than 30 years; and
(iv) the creditor operates predominantly in rural or underserved areas, originates a limited number of mortgage loans annually as set in the regulation, retains the balloon loans in portfolio, and meets other criteria established by the Board, including asset size threshold.

When computing total points and fees, one of the amounts below must be excluded, but not both: (i) up to and including two bona fide discount points but only if the interest rate from which the mortgage’s interest rate will be discounted does not exceed the average prime offer rate by more than 1%; or (ii) unless two bona fide discount points have been excluded under (i) above, up to and including one bona fide discount point payable by the consumer, but only if the interest rate from which the mortgage’s interest rate will be discounted does not exceed the average prime offer rate by more than 2%.

With regard to smaller loans, the 3% points and fees limit in the safe harbor may be adjusted by the Board by regulation. The Board is to consider the rule’s potential impact on rural areas and other areas where home values are lower.

As with the restrictions on steering, the failure to determine ability to repay may be raised as a defense by recoupment or set-off of any action to collect a debt on a residential mortgage loan. See previous Bulletin for further discussion.

Section 129C becomes effective 12 months after the Board issues final regulations and guidelines. The Mortgage Act requires the Board to issue final regulations within 18 months after the transfer date, which is the date that responsibility over enumerated consumer protection laws are transferred from the federal banking agencies to the new Consumer Financial Protection Bureau.

  1. These are HUD, the the Department of Veterans Affairs, the Department of Agriculture, and the Rural Housing Service.
  2. The term “fully indexed rate” is the applicable index rate at origination plus the margin that will apply after the expiration of any introductory interest rates.
  3. The term is defined as the average prime offer rate for a comparable transaction as of the date the interest rate is set, as published by the Board.
  4. For purposes of this provision, “bona fide discount points” means discount points which are knowingly paid by the consumer to reduce the interest rate and which in fact result in a reduction of the interest rate or the time-price differential. The amount of the reduction purchased must be reasonably consistent with industry standards, or else the discount points may not be excluded.

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.

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