By Tom LaChac and Wendy Iannone
On January 10, 2013, the Consumer Financial Protection Bureau (“CFPB”) released its final Ability-to-Repay (“ATR”) and Qualified Mortgage Rule, effective January 10, 2014. Our Subject Matter Experts in our Regulatory Compliance Department have reviewed the rule(s) and subsequent implementation and have complied what we hope is useful information for your Institution.
Not so much out of the blue
The Ability-to-Repay rule has been oncoming like a slow train over the horizon. Everybody saw it; every institution knew it was coming, but the level of preparedness for it actually pulling into the station greatly varies depending on the strength of an institution’s compliance area.
A quick history lesson tells us that the origins of the ATR rule began back in 2009, when the “Great Recession was in full bloom. One of the biggest contributing factors to the troubles was the manner in which many mortgages were underwritten without regard to the borrower’s ability to repay the loans.” Certain underwriting criteria in this timeframe left many questions and loopholes for regulators to scrutinize. There were certain programs that thrived in which an income check on a potential borrower wasn’t even necessary. Loans were also approved based on initial rates which would allow a borrower to make their first payments, but after a certain period of time, the payments would jump up to a level which the borrower simply could not afford anymore.
As a result, the Federal Reserve System instituted new criteria under the Truth in Lending Act (“TILA”) by preventing lenders originating from underwriting mortgage loans without a complete assessment of the borrower’s ability to repay the loans.
In 2010, the US Congress, under the Dodd-Frank Act, adopted the Ability-to-Repay requirements for just about every closed-end type of consumer (residential) mortgage loan product. In the same vein, Congress also set up a “presumption of compliance” with the Ability-to-Repay requirements for a specific sub set of mortgage loans, the aptly named Qualified Mortgages (“NMS”).
Ok, so it’s here.
Yes it is. Like that house guest who somehow has made your couch his new bungalow, the ATR rules aren’t going anywhere. So how does a community bank cope?
The CFBP guide lays out minimum standards that an institution is required to use to ensure that a borrower will have the ability to repay the mortgages they sign for. Lenders are required to make a “reasonable good faith determination of an applicant’s ability to repay”. But what constitutes reasonable? A common sense approach would be to obtain adequate documentation to verify income and obligations, and to use realistic rate of interest and repayment terms. The ultimate goal is to ensure that at the time the credit decision is made, the information used in the determination supports the conclusion that the borrower will be left with sufficient residual income or assets to meet living expenses.
The ATR rule lays out eight factors that a bank must include in its assessment of a borrower’s Ability-to-Repay (similar to qualitative factors in the Allowance for Loan Loss, but that’s a whole other regulatory headache). However, there are no requirements that an institution has to follow a specific set of underrating guidelines.
So with that in mind, let’s dig into what needs to be done. Per Regulation Z, Section 1026.43, “a creditor makes 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."
This applies to all residential mortgages, including purchases, refinances, and home equity loans, and covers both first and second liens. The ATR rule does not cover commercial lending, even if secured by a personal dwelling. It also does not apply to loans for timeshares, reverse mortgages, loan modifications, and temporary bridge loans.
Below are the eight cornerstone factors of the ATR rule:
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. Ensure that reliable third party records are obtained to verify the information used in evaluating the following factors.
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 should be calculated by assuming that the loan is repaid in substantially equal monthly payments to avoid the potential pitfalls of using an introductory rate or basing repayment on a balloon payout. The general rule requires that monthly payments are based upon the highest payment that will apply in the first five years of the loan.
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. As repayment terms for open end credit cannot be accurately predicted, it is best to avoid credit requests that rely on secondary financing. If unavoidable, be mindful of a simultaneous loan structured as open end credit to avoid the rule.
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. For both new construction and home improvement financing there is a potential that the assessed value of the dwelling will be subject to change. Future real estate tax payments could increase if the current assessment is for land only or if the structural improvements being financed are known to trigger a reassessment by the municipality.
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. Generally, total debt-to-income should be less than 43 percent. Although there may be exceptions, using this benchmark provides a bright line for creditors who want to make qualified mortgages. There may be instances where a debt-to-income ratio in excess of 43 percent would afford the consumer sufficient residual income for living expenses, but such loans are better evaluated on an individual basis under the ability to repay criteria than with a blanket presumption.
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 the borrowers' ability to repay the loan. It is important to note that the longer the borrower has demonstrated the actual ability to repay a loan by making timely payments, the less likely it is that a challenge can be made to the ATR presumptions that were utilized.
If a bank is using prudent or conservative underwriting standards then much, if not all, of the above will be included in a standard review of a borrower’s Ability-to-Repay. This, of course, leads to the Qualified Mortgage and Safe Harbor rules, which further drill down what a bank may or may not do in granting a loan to a perspective borrower. Essentially, if a bank is operating in good faith and a reasonable manner to ensure that borrowers can afford the loan(s) offered, and are prudently documenting their efforts, the ATR rule can be more of a help than a hindrance to its bottom line.
Thomas LaChac is an Associate Director of P&G Associates, and brings a wide range of experience in regulatory underwriting, quality assurance, regulatory compliance management and the banking and mortgage industries.