On January 10, 2013, the Consumer Financial Protection Bureau (the “CFPB”) adopted final rules (including their official commentary, the “Rules”)1 implementing the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act or 2010 (the “Dodd-Frank Act”)2 for residential mortgage lenders to consider borrowers’ ability to repay before extending credit. The Rules also define the long-anticipated category of “qualified mortgages” that will enjoy a presumption of compliance with the ability-to-repay rules, and specify when that presumption will be conclusive or rebuttable.
The Rules are of obvious importance to mortgage originators. The Rules also will be of great concern to participants in the secondary mortgage markets and the mortgage securitization industry, who must determine among themselves how they will allocate potential liabilities arising under the Rules, whether by representations and warranties or otherwise. In addition, the Dodd-Frank Act requires that the yet-to-be defined category of “qualified residential mortgages” that are exempt from the upcoming credit risk retention requirements for securitizations3 be no broader than the definition of “qualified mortgage” under the ability-to-pay rules. The adoption of the definition of “qualified mortgage” should remove a significant impediment to the finalization of the credit risk retention rules by the relevant Federal regulators.
The Rules will take effect on January 10, 2014.
Section 129C of the Truth in Lending Act (“TILA”), as added by Sections 1411 and 1412 of the Dodd-Frank Act, requires a residential mortgage lender to make a reasonable and good faith determination based on verified and documented information that the borrower has a reasonable ability to repay his or her loan according to its terms.
The Rules requires lenders to consider eight factors when underwriting a mortgage loan and determining the borrower’s ability to repay:
While a lender’s underwriting practices must take these factors into account, the Rules do not require it to use any particular models to do so, so long as its standards lead to determinations made reasonably and in good faith. Generally, a lender must use “reasonably reliable” third party records to verify the information supporting its underwriting decision.
The Rules and their associated commentary provide several examples of how the required factors are to be applied. Monthly payments generally must be calculated assuming substantially equal monthly payments. Adjustable-rate mortgage (“ARM”) payments must be calculated using the higher of the introductory rate or fully indexed rate. There are specific rules addressing how payments on balloon, interest-only and negative amortization loans must be calculated.
The Rules encourage lenders to refinance their “nonstandard mortgages” into “standard mortgages” that have fixed rates for at least five years.
Reasonable and In Good Faith
The lender must make a reasonable and good faith determination, at or before consummation, that the borrower will have a reasonable ability to repay the loan according to its terms, including any mortgage-related obligations. (“Consummation” means when the borrower becomes obligated on the loan, which ordinarily will be at closing.) Lenders may use their own proprietary underwriting standards, so long as they take all of the required factors into account.
According to the Rules, early payment default may be evidence that an ability-to-pay determination was not made reasonably and in good faith, whereas actual timely payments for a significant period of time may be evidence that the determination was made reasonably and in good faith. Lenders may consider it troublesome that an early payment default could indicate the unreasonableness of their underwriting standards, no matter how much care was put into them, and that actual timely payments are not determinative of the reasonableness of their underwriting standards.
Current or Reasonably Expected Income or Assets
In an effort to avoid lender reliance on the possibility of rising home values to permit the borrower to repay its obligations, a lender may not consider the value of the borrower’s home in making its determination of the borrower’s current or reasonably expected income or assets. If the lender bases its determination in any part on the borrower’s income, it need consider only the income required to support its determination. Where there are joint applicants and the income or assets of only one is sufficient to support the lender’s underwriting determination, the lender need not consider the income or assets of the other applicant.
Current Employment Status
Employment status need be considered only if the lender relies on income from that employment in determining repayment ability. Employment may be verified orally, as further described below.
Monthly Payment on the Loan
In calculating the monthly payment on the loan, the lender must use a fully amortizing payment schedule and assume that all loan proceeds are fully disbursed on the date of consummation and that the loan is repaid in substantially equal monthly amortizing payments over its entire term. The interest rate to be used is the greater of the fully indexed rate as of the consummation date and any introductory rate. The fully indexed rate must be determined without regard to any interest rate caps, but the lender may choose to take into account a lifetime maximum interest rate. There are special rules for calculating the monthly payment on balloon loans, loans that allow deferral of principal or interest, interest-only loans and negative amortization loans.
Monthly Payment on Any Simultaneous Loan
A “simultaneous loan” is another mortgage or home equity line of credit (“HELOC”) secured by the same dwelling and made to the same borrower at or before the consummation of the mortgage in question. The lender must consider the monthly payment on any simultaneous loan that it “knows or has reason to know” will be made. According to the Rules, a lender complies with the “reason to know” standard if it “follows policies and procedures designed to determine whether at or before consummation that the same consumer has applied for another credit transaction secured by the same dwelling.” The monthly payment on a simultaneous HELOC is calculated by the amount the lender knows or has reason to know is to be drawn at consummation.
Monthly Payment for Mortgage-Related Obligations
The “mortgage-related obligations” which must be considered by the lender in its underwriting process include property taxes, insurance premiums required by the lender, fees and special assessments imposed by a condominium, cooperative or homeowners’ association, ground rent and leasehold payments. According to the official commentary, estimates of mortgage-related obligations should be based on information known to the lender, and information is deemed to be known if it is “reasonably available” to the lender at the time of underwriting. The Rules contain special provisions addressing the calculation of special assessments, community transfer fees, and pro rata monthly mortgage-related obligations.
Current Debt Obligations, Alimony and Child Support
While the Rules give examples of what constitutes current debt obligations, they do not provide an exhaustive list. Lenders may develop their own underwriting guidelines regarding consideration of current debt obligations, including how to treat obligations that are likely to be paid off soon after closing and obligations that are in forbearance or deferral, so long as they lead to reasonable, good faith ability-to-repay determinations. The lender must consider the debt obligations of all joint applicants, but is not required to consider the debt obligations of a surety or guarantor.
Monthly Debt-to-Income Ratio or Residual Income
A lender may consider either the borrower’s monthly debt-to-income ratio or residual income in making its ability-to-repay determination. In contrast to the quantitative standard required for determining whether a mortgage is a qualified mortgage (as discussed below), the Rules permit a flexible approach to evaluating the borrower’s debt-to-income ratio or residual income. No specific debt-to-income ratio or residual income is required, and the lender may use compensating factors in determining that the borrower has the ability to repay, despite a higher debt-to-income ratio or lower residual income, so long as the end result supports a reasonable and good faith determination of repayment ability.
The lender has significant flexibility in how to consider credit history, and may consider credit bureau reports or nontraditional credit references such as rental payment history or public utility payments. There is no requirement to obtain a credit score.
Verification Using Third-Party Records
TILA requires that the ability-to-pay determination be based on “verified and documented information.” The Rules implement this requirement by requiring that the lender use reasonably reliable third-party records, with two exceptions. First, employment status may be verified orally, so long as the lender prepares a written record of the discussion. Second, where the lender relies on a credit report to verify current debt obligations and the borrower’s application includes a current debt obligation not shown on the credit report, the creditor does not have to verify the additional debt obligation.
A credit report generally is considered a reasonably reliable third-party record, and the lender generally is not required to do anything else to verify information in the credit report. Records obtained from the government also are deemed to be reasonably reliable. Records may be obtained from a third-party service provider or directly from the borrower, so long as the records are reasonably reliable. Settlement statements and other documents provided in final form at closing are not reasonably reliable, because the ability-to-repay determination should be made in advance of closing.
Income and assets may be verified using tax returns, W-2s, payroll statements, bank records, and other reasonably reliable third-party documents. Third-party tools that rely on statistically qualified models rather than individual data may not be used.
Refinancing of Non-Standard Mortgages
When a “non-standard mortgage” is refinanced into a “standard mortgage,” the lender need not comply with the Rules’ ability-to-pay requirements. A non-standard mortgage is an ARM with an introductory interest period of a year or more, an interest-only loan, or negative amortization loan. A standard mortgage has regular periodic payments that do not cause the principal balance to increase, does not allow the consumer to defer repayment of principal and does not result in a balloon payment. Total points and fees on a standard mortgage may not exceed the level required for a qualified mortgage, as described below (generally, three percent, with certain exceptions for small loans), the term cannot exceed 40 years, and interest must be fixed for at least the first five years.
For a refinancing to qualify for this exception, several conditions must be met. The proceeds of the new loan may be used only to pay the outstanding balance of the refinanced non-standard mortgage and closing or settlement charges. The new lender must be either the holder or servicer of the existing non-standard mortgage. The monthly payment must be “materially lower,” with a safe harbor for a ten percent or greater reduction. The borrower’s written application must be received no more than two months after the existing non-standard mortgage is “recast.” This means the expiration of the introductory interest period for an ARM, the expiration of the period when interest-only payments are permitted for an interest-only loan, and the expiration of the period during which negatively amortizing payments are permitted for a negative amortization loan. The borrower must have made no more than one payment more than 30 days late during the 12 months preceding receipt of the borrower’s application, and have made no payment more than 30 days late during the six months preceding receipt of the borrower’s application. Finally, in order to avoid evasion of the ability-to-pay requirements, if the non-standard mortgage closed after January 10, 2014, either the lender must have complied with the ability-to-pay requirements or the loan must be a qualified mortgage.
The ability-to-pay requirements cover any consumer credit transaction secured by a dwelling, other than HELOCs, timeshare loans, reverse mortgages and temporary loans (such as construction or bridge loans) of 12 months or less. They apply to any lender making six or more such loans in a calendar year, even for self-financed sales. For temporary loans, the term is determined without reference to the possibility of renewal. For construction-to-permanent loans, the permanent phase is covered, while the construction phase is not (so long as it qualifies for the exemption for temporary loans).
Presumption of Compliance for Qualified Mortgages
TILA provides that “qualified mortgages” are entitled to a presumption of compliance with the ability-to-pay rules. As adopted, the Rules bifurcate the types of presumption that are available for originators of qualified mortgages.
For qualified mortgages that pose the least risk, the Rules provide a safe harbor. For “higher-priced” qualified mortgages, the lender’s presumption of compliance with the ability-to-pay rules is rebuttable. A “higher-priced” mortgage has an APR that exceeds the APOR by one and one half percentage points for first liens, and three and one half percentage points for subordinate liens. The APOR is the average prime offer rate for a comparable transaction as of the date on which the interest rate is set, as published by the CFPB.
The borrower may rebut the presumption of compliance for a higher-priced mortgage by showing that, at the time of origination, his or her income and debt obligations left insufficient residual income or assets to meet living expenses, considering monthly payments on the loan, mortgage-related obligations, and any simultaneous loans of which the lender was aware, and any recurring, material living expenses of which the lender was aware. The CFPB acknowledges the increased litigation potential for higher-priced qualified mortgages, but does not believe that these risks will have a significant adverse impact on credit availability. We expect that lenders may differ from the CFPB in their assessment of the expected results of the rebuttable presumption.
What Is a Qualified Mortgage?
The Rules define a “qualified mortgage” as a loan that satisfies all of the qualified mortgage requirements of Section 129C of TILA, in addition to certain additional requirements imposed by the CFPB. For a loan to be a qualified mortgage, generally:
Negative Amortization, Interest-Only and Balloon Loans
A qualified mortgage must provide for regular periodic payments that amortize the entire loan over its term. Therefore, a qualified mortgage may not result in an increase of the principal balance (i.e., a negative amortization loan), allow the consumer to defer repayment of principal (e.g., interest-only and graduated payment loans), or (except under the special exemption described below) result in a balloon payment.
Maximum Term of 30 Years
For purposes of calculating the term of the loan, any interim period between consummation and the beginning of the first full payment period is ignored. A refinancing that results in the satisfaction and replacement of the original loan is considered a new loan that must comply with the ability-to-pay requirements, or be a qualified mortgage. However, a transaction that does not constitute a refinancing is a mere extension of the original loan, and the ability-to-pay or qualified mortgage requirements apply only at the consummation of the initial transaction.
Underwritten Interest Rate and Payment
In underwriting the loan, the underwriter must take into account all mortgage-related obligations. The lender must underwrite the loan using the maximum interest rate that may apply during the first five years after the first payment due date on the loan. For an ARM, the lender must assume the maximum rate of increase in the interest rate, subject to any periodic interest rate adjustment caps. For a step-rate mortgage, the lender must use the highest rate that will occur during the first five years. In addition, the lender must underwrite the loan using periodic payments of principal and interest that will repay either the loan amount over its term, or the remaining outstanding principal balance as of the date the interest rate adjusts to the assumed maximum rate, assuming the borrower has made all required payments due before then.
The lender must consider and verify the borrower’s current or reasonably expected income or assets, other than the value of the mortgaged dwelling (which for this purpose includes any related real property). Current debt obligations, alimony and child support also must be considered and verified in accordance with specific guidelines and standards that are based on FHA guidelines. The results of this analysis are then used to determine whether the borrower satisfies the debt-to-income ratio requirement described below.
The CFPB notes that, while qualified mortgages are exempt from the ability-to-pay rules, most of the ability-to-pay requirements still must be considered in making the required debt-to-income ratio analysis.
The CFPB adopted a bright-line debt-to-income ratio requirement of 43 percent. This ratio must be calculated in accordance with specific guidelines and standards that are based on FHA guidelines.
The CFPB rejected the use of additional compensating factors or a multi-factor test, on the grounds that these approaches would be too complex and would “undermine the goal of ensuring that creditors and the secondary market can readily determine whether a particular loans is a qualified mortgage.” Given that higher-priced qualified mortgages only carry a rebuttable presumption of compliance with the ability-to-pay requirements, which can be rebutted by the borrower’s facts-and-circumstances demonstration that his or her income and debt obligations left insufficient residual income or assets to meet living expenses, it is not clear that the CFPB’s qualified mortgage rules completely meet their stated goal of regulatory certainty.
Points and Fees Limitation
The general qualified mortgage limitation set forth in TILA for points and fees is that they may not exceed 3 percent of the total loan amount. The CFPB exercised its adjustment authority to permit higher amounts of points and fees in connection with smaller loans, adopting a tiered schedule based on loan size:
The fixed dollar amounts in the schedule are to be indexed for inflation.
For these purposes, points and fees include only charges payable in connection with the loan transaction, which is defined to mean that charges are included in points and fees only if they are “known at or before consummation.”
Charges for a subsequent loan modification are not to be included because they are not known at consummation of the original loan. On the other hand, the maximum prepayment penalties that may be charged under the new loan do constitute points and fees, because they are known at consummation. Prepayment penalties incurred if the borrower is refinancing his or her current loan with its existing holder or servicer (or an affiliate of either) are included.
All items that are included in the “finance charge” for purposes of TILA, except interest or time-price differential, are included in points and fees. Federal loan guarantee charges are excluded, as are premiums for Federal or state mortgage insurance or guarantee fees. All charges for private mortgage insurance are excluded if they are payable after consummation. Charges for private mortgage insurance payable at or before consummation also are excluded to the extent that they do not exceed the amount of the Federal Housing Administration’s (“FHA”) allowable upfront mortgage insurance premiums (i.e., the amount payable under section 203(c)(2)(A) of the National Housing Act, provided that it is required to be automatically refundable on a pro rata basis on notification that the loan has been satisfied). Charges payable at or before consummation for credit life, credit disability, credit unemployment or credit property insurance and the like are included.
Bona-fide third party charges generally are excluded from points and fees if not retained by the lender, loan arranger or any of their affiliates. Therefore, settlement charges paid to third parties are excluded, whereas settlement charges paid to affiliates of the lender are included. Points charged to offset loan level price adjustments are included in points and fees.
Up to two “bona fide discount points” may be excluded from points and fees if the pre-discount interest rate does not exceed the APOR by more than two percentage points, and up to one bona fide discount point may be excluded if the pre-discount interest rate does not exceed the APOR by more than one percentage point. A discount point is “bona fide” if it reduces the interest rate or time-price differential based on a calculation that is “consistent with established industry practices.”
Under TILA, points and fees include all compensation paid directly or indirectly by a consumer or creditor to a mortgage originator from any source. This includes compensation paid to mortgage brokerage firms, individual brokers, and employees of the lender such as its loan officers. Despite extensive industry comment, the CFPB did not waive the statutory requirements as they apply to individual loan originators, such as loan officers. The CFPB did clarify that compensation must be counted towards points and fees only if can be attributable to the specific transaction at the time the interest rate is set. Therefore, individual employee compensation must be included in points and fees only if it can be attributed to a particular transaction. This could result in double-counting, as loan originator compensation that is recovered through origination charges is already included in points and fees. While the Rules do not yet address this issue, the CFPB has requested additional comment on this topic and intends to determine whether to require double-counting before the Rules become effective.
Temporary Accommodation for GSE-Eligible Mortgages
The CFPB adopted a temporary rule defining as a qualified mortgage loans that meet the prohibitions on certain risky features (i.e., no negative amortization, interest-only or graduated payments or balloon payments, the 30 year term limit and the limit on points and fees) and are eligible for purchase or guarantee by the government-sponsored enterprises (“GSEs”) such as Fannie Mae and Freddie Mac, or eligible to be insured or guaranteed by the FHA, the Veteran’s Administration (the “VA”), the Department of Agriculture (the “USDA”) or the Rural Housing Service (the “RHS”). The CFPB notes that the FHA, the VA, the USDA and the RHS have the authority to develop qualified mortgage standards for their own loans, so coverage under the temporary rule ends when they do so. Coverage of GSE-eligible loans will sunset when conservatorship ends. This temporary rule expires on January 10, 2021.
According to the CFPB, the purpose of this temporary rule is to give the nonqualified mortgage market time to develop, though it is not completely clear how a rule providing a special break for GSE-eligible nonqualified mortgages will encourage the development of a broader nonqualified mortgage market.
Balloon-Payment Qualified Mortgages
The Rules provide a special exception for certain balloon mortgages, permitting them to be qualified mortgages if they meet all of the other requirements and if the lender:
This rule is intended to benefit small portfolio creditors, which the CFPB believes are more likely to rely on balloon-payment mortgages to manage interest rate risks and to retain their loans in portfolio.
Other Prepayment Penalty Rules
TILA Section 129C(c)(1)(A) provides that no residential mortgage loan, whether a covered transaction or otherwise, may include a prepayment penalty unless the transaction is a qualified mortgage. The Rules implement this statute by providing that a covered transaction may not include a “prepayment penalty” unless it is otherwise permitted, by law, the transaction is a qualified mortgage, and the transaction has an APR that cannot increase after consummation. Therefore, only qualified mortgages that are fixed-rate or step-rate may contain prepayment penalties. Prepayment penalties in ARMs are prohibited.
Neither reverse mortgages nor temporary loans with a term of twelve months or less are “residential mortgage loans” under TILA. For this reason, they are not subject to the ability-to-pay rules, nor can they be qualified mortgages. Therefore, reverse mortgages and temporary loans cannot contain prepayment penalties.
Even a qualified mortgage cannot contain a prepayment penalty if it is a higher-priced mortgage, as described above.
Even where otherwise permitted (i.e., for qualified fixed-rate or step-rate mortgages that are not higher-priced), no prepayment penalty may be imposed more than three years after the loan is consummated. Further, prepayment penalties are limited to:
Alternative Offer Without Prepayment Penalty
If a lender offers a covered transaction with a prepayment penalty, it must also offer an alternative covered transaction without a prepayment penalty. The alternative transaction must have an APR that cannot increase after consummation and must be the same type of interest rate as the original offer, meaning that both must be fixed-rate mortgages or both must be step-rate mortgages. The creditor must have a good-faith belief that the borrower is likely to qualify for the alternative loan. The alternative loan must have the same term as the loan with the prepayment penalty, and must satisfy the periodic payment conditions and points and fees conditions for qualified mortgages. The alternative loan may be higher-priced, even though the offered loan with the prepayment penalty may not be.
If the loan with the prepayment penalty is offered by a mortgage broker, the lender may either present its own alternative to the mortgage broker, or arrange with the broker to present the borrower with an alternative offer from either the same lender or another lender (if the other lender offers a lower interest rate or a lower total dollar amount of discount points and origination fees). If the loan with the prepayment penalty is offered by a loan originator and the loan would be assigned to another person after consummation, the required alternative may be offered either by the assignee, or by another person (if the other person offers a lower interest rate or a lower total dollar amount of discount points and origination fees).
The Dodd-Frank Act created special remedies for violation of the ability-to-pay requirements. A borrower who brings a timely action for violation of the ability-to-pay rules may recover special statutory damages in an amount equal to the sum of all finance charges and fees he or she paid, unless the lender can demonstrate that the failure to comply was not material. These statutory damages are in addition to the recoveries generally permitted for TILA violations, which include actual damages, statutory damages up to certain prescribed thresholds, and courts costs and attorneys’ fees.
The statute of limitations for a violation of TILA Section 129C is three years from the date of occurrence of the violation, as opposed to the one year standard for most other TILA violations.
In addition to suing for monetary damages, a borrower can assert a violation of the ability-to-pay rules in defense to any foreclosure action bought by the lender, an assignee, any other holder or an agent of any of them “as a matter of defense by recoupment or setoff.” There is no time limit on this defense, though the amount of recoupment or setoff with respect to the special statutory damages is limited to three years of finance charges and fees.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Sweet-Charles
1 Ability-to-Repay and Qualified Mortgage Standards under the Truth in Lending Act, available at http://files.consumerfinance.gov/f/201301_cfpb_final-rule_ability-to-repay.pdf.
3 Our guide to the proposed credit risk retention rules is available at http://www.bingham.com/Alerts/Files/2011/04/A-Guide-to-the-Proposed-Credit-Risk-Retention-Rules-for-Securitizations.
This article was originally published by Bingham McCutchen LLP.