PLAYING BY THE NEW RULES: A GUIDE TO ATR/QM AND LOAN ORIGINATOR COMPENSATION

Transcription

1 PLAYING BY THE NEW RULES: A GUIDE TO ATR/QM AND LOAN ORIGINATOR COMPENSATION Module 1 Learning Objectives In Module 1, course participants will review the following topics related to the statutory and regulatory requirements for assessing the repayment ability of borrowers: Trends in requirements for assessing repayment ability from 1980 to the present Requirements created by the Dodd-Frank Act for the assessment of repayment ability Relaxed underwriting standards for transactions involving the refinancing of a nonstandard mortgage with a standard mortgage Topics related to the Qualified Mortgage Rule (QM Rule), including: o The definition of a qualified mortgage o Underwriting requirements for qualified mortgages o The debt-to-income ratio requirement for qualified mortgages o The difference between conclusive and rebuttable presumptions of compliance o Temporary qualified mortgages o Restrictions on prepayment penalties o Liability for violation of the rules Several Discussion Scenarios based on the reading material in Module 1 Introduction One of the most anticipated rules issued by the Consumer Financial Protection Bureau (CFPB) is the Ability to Repay/Qualified Mortgage Rule (ATR/QM Rule). The CFPB issued this as a final rule on January 10, 2013, and it became effective on January 10, The statutory source of authority for this rule is Title XIV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which mandates the consideration of the repayment ability of consumers who are shopping for home loans. The law states: no creditor may make a residential mortgage loan unless the creditor makes a reasonable and good faith determination based on verified and documented information that, at the time the loan is consummated, the consumer has a reasonable ability to repay the loan according to its terms, and all applicable taxes and insurance and assessments (H.R (a)). 1

2 The law provides that when creditors make qualified mortgages, purchasers or assignees of such loans may presume that the loan has met the requirements for establishing the borrower s repayment ability. The Rule also benefits assignees or purchasers of mortgages in the secondary market because the making of a qualified mortgage is less risky than a loan that is not a qualified mortgage (H.R (b)(1)). The Dodd-Frank Act lists the factors that creditors must use in assessing repayment ability and outlines the criteria for determining whether a home loan is a qualified mortgage. The practical details of complying with the law are outlined in the ATR/QM Rule. The Federal Reserve Board (the Board) wrote the proposed rule outlining ability-to-repay and qualified mortgage standards before rulemaking authority passed to the CFPB. Shortly after the CFPB inherited the Board s rulemaking authority on July 21, 2011, it initiated efforts to produce a final rule that protects the interests of both consumers and the mortgage industry. The final regulations are the product of meetings with stakeholders on all sides, and rigorous analysis and research 1 The ATR/QM Rule is found in of the Code of Federal Regulations (C.F.R.). Subsections (c) and (d) of the Rule address the requirement to assess repayment ability for nonqualified mortgages and the underwriting criteria that creditors must use when making this assessment. These subsections also establish the underwriting standards for loans that are nonqualified mortgages. In this course, Subsections (c) and (d) of the Rule are generally referred to as the ATR Rule. Subsection (e) of the Rule addresses the characteristics of qualified mortgages and the underwriting guidelines that creditors must follow when making them. This Subsection also creates the temporary guidelines for making qualified mortgages under less rigorous standards during the first seven years following the Rule s effective date. In this course, these sections of the Rule are generally referred to as the QM Rule, and they include an outline of the provisions of Subpart (g) of the new rules. Subpart (g) addresses prepayment penalties, which are restricted from most transactions, with the exception of fixed-rate qualified mortgages. Throughout this course, there are references to the Rule s Preamble, as well as to the CFPB s Official Interpretations of the Rule. These resources are helpful when interpreting the meaning of statutory and regulatory language, and are particularly useful when new laws and regulations represent a significant departure from prior legal requirements. The Preamble offers insight into how the CFPB weighed concerns raised by consumers and by industry professionals during rulemaking proceedings. The Official Interpretations show how the CFPB, as a supervisory and enforcement agency, will apply these rules when evaluating creditors compliance with them. These resources are accessible online, and are easiest to find through the CFPB website. 2 1 CFPB. Protecting Consumers from Irresponsible Mortgage Lending. 10 Jan. 2013, page CFPB. Ability to Repay and Qualified Mortgage Standards under the Truth in Lending Act (Regulation Z). 2

3 The statutory authority for these new rules and the statutory requirements discussed in this course are found in the Truth-in-Lending Act (TILA), and are applicable to creditors. Before learning about the ATR/QM Rule, it may be helpful to recall that TILA defines a creditor as any person, including natural persons and organizations, that: Regularly extends credit which is: o Payable in more than four installments, and o Subject, or may be subject, to a finance charge Is the one to whom the debt is initially payable (12 C.F.R (a)(17)) Mortgage lenders fall within this definition. Another term used throughout this course is consummation. Under Regulation Z, consummation refers to the time at which a consumer becomes contractually obligated in a credit transaction (12 C.F.R (a)(7)). A consumer becomes contractually obligated when he or she signs a lending agreement. Typically, this occurs at closing. Historical Perspective on Ensuring a Borrower s Repayment Ability It was the movement towards deregulation in the 1980s that led to the demise of common-sense rules for mortgage lending. The Alternative Mortgage Transactions Parity Act (AMTPA) of 1982 is an example of a federal law that freed lending from the restraints of regulation. This law preempted state statutes that restricted banks from making home loans other than fullyamortizing fixed-rate loans. The AMTPA ushered in the origination of nontraditional mortgage products, such as adjustable-rate mortgages (ARMs). When abusive and predatory lending practices began to invade this free market, Congress responded with the 1994 enactment of the Home Ownership and Equity Protection Act (HOEPA). This law revived the concept of requiring creditors to determine a borrower s ability to repay, but limited this requirement to transactions involving expensive subprime mortgages that tripped high threshold requirements. Furthermore, this requirement, as established in the first version of HOEPA, applied only to lenders that had demonstrated a pattern or practice of asset-based lending. In 2008, the Federal Reserve Board rewrote Regulation Z to prohibit high-cost lending by all creditors unless they began the transaction with an analysis and verification of the borrower s ability to repay. The same year, the Board adopted another rule establishing a category of loans known as higher-priced mortgage loans, with thresholds that were low enough to apply to most loans in the subprime market. Under the Higher-Priced Mortgage Rule, creditors cannot make mortgages without considering the borrower s verified income and assets, credit score, and debtto-income ratio. These regulations, now found in 12 C.F.R , require verification using tax returns, payroll receipts, and other reliable third-party documents. 3

4 Unfortunately, these regulations for high-cost home loans and higher-priced mortgages were too late to impact the lending market, which had already unraveled. Two years later, when Congress included provisions in the Dodd-Frank Act imposing ability-to-repay requirements on all mortgage lending transactions, there was even less hope of undoing the mess that the mortgage market had become, and the law represented an attempt by Congress to ensure that such catastrophic losses would never occur again. While relaxed underwriting and lending standards were prevalent, consumers took advantage of these market conditions by purchasing residential properties that they were ultimately unable to afford. They made these purchases by accepting mortgage products like no-doc and low-doc loans, with terms that led to negative amortization, frequent interest rate resets, and growing monthly payments. As countless borrowers faced mortgage payments that were beyond their means, the number of delinquencies and foreclosures escalated. Statutory Requirement to Assess Repayment Ability In order to prevent underwriting standards from deteriorating again, the Dodd-Frank Act added provisions to TILA to establish minimum standards for residential mortgage loans. These standards are set forth in Subtitle B of Title XIV, which is known as the Mortgage Reform and Anti-Predatory Lending Law. The requirement for creditors to evaluate the repayment ability of consumers who apply for residential mortgage loans is found in 1411 of Title XIV. Before reviewing these new statutory requirements, it is important to understand how the law defines the term residential mortgage loan. Under TILA, a residential mortgage loan is a consumer credit transaction that is secured by a mortgage, deed of trust, or other consensual security interest on a dwelling or residential real property that includes a dwelling. Excluded from this definition are: Open-end credit plans secured by a mortgage, deed of trust, or other security interest, and Extensions of credit related to timeshare plans (15 U.S.C. 1602(cc)(5)) In addition to these exclusions, the Dodd-Frank Act exempts the following types of residential mortgage loans from the requirement to assess repayment ability: Reverse mortgages, and Bridge loans with terms of 12 months or less (15 U.S.C. 1639(a)(8)) After prohibiting creditors from making residential mortgage loans without making a reasonable and good faith determination that a consumer can repay the debt, the new provisions of TILA require this assessment to be based on the following factors: Credit history Current income 4

5 Reasonably-expected income Current obligations Debt-to-income ratio Employment status Other financial resources, excluding home equity, and A payment schedule that fully amortizes the loan by the end of the loan term (15 U.S.C. 1639C(a)(3)) The law not only requires creditors to consider income, but also requires that they verify income and other assets used to determine repayment ability by reviewing: IRS W-2 forms Tax returns Payroll receipts Financial institution records, and Other third-party documents providing reasonably reliable evidence of the consumer s income or assets (15 U.S.C. 1639C(a)(4)) Prohibited and Required Lending Practices under the Dodd-Frank Act (15 U.S.C. 1639C) In establishing minimum standards for residential mortgage loans, the Dodd-Frank Act addresses a number of lending practices that were popular before the market collapsed, making these practices illegal or forbidding their use without additional safeguards. As a further effort to prevent consumers from finding themselves in mortgages that they cannot afford to repay, the law includes provisions that address: Equity-based lending Piggyback loans, and Non-standard loans Equity-Based Lending One practice during the lending boom that ultimately led to defaults and foreclosures was basing lending decisions primarily, if not solely, on equity in the dwelling that would secure the loan. In its Preamble to the ATR Rule, the CFPB observed that there is evidence that loans were made solely against collateral, or even against expected increases in the value of collateral, and without consideration of ability to repay. 3 In many cases, inflated appraisals helped consumers to secure these loans, increasing the number of those who were left underwater, or owing more on their homes than they were worth FR 6410 (Jan. 30, 2013) 5

6 In order to prevent the future use of these practices and their devastating consequences, the law: Prohibits lenders from using the equity in the dwelling that will secure the loan as the only basis for extending credit, and Requires lenders to determine repayment ability using a payment schedule that fully amortizes the loan over the loan term (15 U.S.C. 1639C(a)(3)) Piggyback Loans Another practice during the lending boom that proved detrimental to consumers and lenders was the simultaneous origination of multiple loans. These piggyback loans were another form of creative financing that allowed consumers to purchase homes that were not realistically within their means. With options such as an loan, consumers financed home purchases by obtaining financing for 80% of the amount with one lender, and dividing the other 20% between two additional lenders. The Dodd-Frank Act discourages this practice by amending TILA to require creditors to make lending decisions using verified and documented information evidencing the consumer s reasonable ability to repay combined payments on the dwelling according to the terms of each loan, including applicable taxes, insurance, and any other assessments. The requirement to make this determination arises whenever the creditor knows or has reason to know that one or more mortgage loans to be secured by the same dwelling are to be made to the same consumer (15 U.S.C. 1639C(a)(2)). Nontraditional or Non-Standard Loans During the lending boom, the mortgage market was full of nontraditional mortgage products. These included the following types of loan products that the Dodd-Frank Act seeks to discourage: Variable-rate loans that defer payments of principal or interest Other mortgage products that result in negative amortization, and Interest-only loans Consumers applied for these products when they were not likely to qualify for traditional, lessrisky mortgages. They succeeded in qualifying for nontraditional loans because creditors made their lending decisions based on the ability of borrowers to make the initial low monthly payments. Payment-option ARMs are just one example of loans that allow borrowers to defer payments of principal or interest. With these loans, the various monthly payment options that borrowers may choose from include 30-year fully-amortizing payments, 15-year fully-amortizing payments, or an established minimum amount that did not reduce the principal or even pay all of the interest due; often resulting in negative amortization, these were very risky mortgages for consumers to take on. Interest-only loans are another type of nontraditional product available before the market crashed. These loans failed to reduce the principal and proved to be poor products for 6

7 homebuyers who intended to remain in their homes for any extended period of time. Special provisions of TILA now refer to ARMs that defer repayment of principal or interest and to interest-only loans as non-standard loans (15 U.S.C. 1639C(a)(6)). The Dodd-Frank Act discourages the origination of these types of non-standard loans by amending TILA to require creditors to use a fully-amortizing repayment schedule when determining a consumer s ability to repay (15 U.S.C. 1639C(a)(6)(A)). Similarly, when making interest-only loans, creditors must assess repayment ability using the payment amount that would be required to amortize the loan by its final maturity date (15 U.S.C. 1639C(a)(6)(B)). These provisions are certain to ensure that creditors will no longer make nontraditional loans. If a loan applicant can qualify for a loan using a fully-amortizing payments schedule, there are very few circumstances in which he or she would opt for a non-amortizing mortgage product. The Dodd-Frank Act directly addresses the calculation process for these types of mortgages, requiring that creditors calculate monthly payment amounts for principal and interest on a residential mortgage loan by assuming the following: Full disbursement of the loan proceeds on the day the loan is consummated Repayment of the loan in substantially equal monthly amortizing payments for principal and interest over the entire term of the loan, with no balloon payment (although there are some exceptions for balloon payment qualified mortgages), and A fixed interest rate over the entire loan term that is equal to the fully-indexed rate when the loan is consummated (15 U.S.C. 1639C(a)(6)(D)) Refinancing of Hybrid Loans (15 U.S.C. 1639C(a)(6)(E)) In addition to creating statutory requirements for an assessment of repayment ability, Title XIV of the Dodd-Frank Act amends TILA by adding provisions to encourage creditors to refinance potentially unaffordable mortgages, which are referred to as hybrid loans, with standard mortgages that are affordable. The goal behind these provisions is to create opportunities for consumers to avoid the payment shock that will occur when their initial fixed interest rates expire and become adjustable. The law encourages these refinances by allowing the creditors that are holding these loans to use more lenient underwriting standards to qualify a consumer for the refinancing. In these transactions, the creditor may base a lending decision on: The consumer s good standing on the existing mortgage, and The possibility that a refinance will prevent a default that is likely to occur when the interest rate for the existing loan resets The law also provides that in these transactions, creditors may offer favorable terms to borrowers that would be available to new customers with high credit ratings based on such underwriting standards. 7

8 The ATR Rule Regulations such as those promulgated by the CFPB address the details and nuances of complying with requirements set forth in the law. The rulemaking process provides a chance for those impacted by new regulations to offer their own interpretations of statutory language. Both the Federal Reserve Board, which initiated the rulemaking proceedings on the ATR Rule, and the CFPB offered the mortgage industry and consumers several opportunities to contribute to the creation of regulations that implement the ability-to-repay provisions of the Dodd-Frank Act. The details of the final rule that resulted from this process are outlined in the following sections. Scope of the ATR Rule (12 C.F.R (a); (b); (c)) The ATR Rule prohibits a creditor from entering a consumer credit transaction that is secured by a dwelling unless the creditor has made a reasonable and good faith determination, at or prior to consummation, that the consumer has a reasonable ability to repay the loan according to its terms. The Rule also provides that a creditor s reasonable and good faith determination must be based on verified and documented information (12 C.F.R (c)(1); (2)). As mandated by provisions of the Dodd-Frank Act, the ATR Rule is very broad and applies to any consumer credit transaction secured by a dwelling; this includes any real property attached to a dwelling (12 C.F.R (a)). Under Regulation Z, a dwelling includes a residential structure of one to four units, including condominium and cooperative units, mobile homes, and trailers, if used as a residence (12 C.F.R (a)(19)). Therefore, the rules apply to any transaction for credit that is secured by any of these types of residences, regardless of whether it is a primary residence or a second home. The parameters of the rule mirror those established in the law, providing that the only transactions not subject to the Rule are those that involve: Open-end home equity plans Timeshare plans Reverse mortgages, and Temporary or bridge loans of 12 months or less The Rule is not applicable to extensions of credit primarily for business, commercial, or agricultural purposes, even if secured by a dwelling. 4 The Fully-Indexed Rate (12 C.F.R (b)(3)) The ATR Rule defines numerous terms, but an accurate understanding of the definition of fullyindexed rate is critical to successful compliance with the Rule when making adjustable-rate mortgages. This definition is important because one of the most essential considerations in determining repayment ability is a consumer s ability to make monthly payments, and because periodic payments are calculated using the fully-indexed rate, with the exception of rare cases in which the introductory rate is higher than the fully-indexed rate. 4 Supplement I, Official Interpretations, 43(a) Scope 8

9 The general definition of fully-indexed rate in the ATR Rule is: The interest rate calculated using the index or formula that will apply after recast, as determined at the time of consummation, and the maximum margin that can apply at any time during the loan term (12 C.F.R (b)(3)). Understanding this definition requires several steps. The first step involves a basic review of how interest rate changes are calculated for ARMs. These changes are based on an index, such as Treasury Securities Rates or the LIBOR, plus the margin, which is the number of percentage points that a creditor will add to the index rate. While an index rate will vary with the movement of interest rates, the margin typically remains the same over the loan s term. The CFPB explains that although there are currently no loan products with a margin that can increase during the loan term, the Rule addresses the possibility that creditors may create future products which permit different margins to take effect at different points throughout the loan s term; thus, requiring calculations to include the maximum margin provides a greater level of protection. 5 The next step in making sense of this definition is to learn how the ATR Rule defines recast. This definition was the subject of many comments and much debate during the rulemaking process. In its Preamble to the Rule, the CFPB noted that the term typically references the time at which fully-amortizing payments are required for interest-only and negative amortization loans. 6 The CFPB devised a similar definition for recast, stating that the term refers to the expiration of the period when: Payments on an ARM may be based on the introductory fixed rate Interest-only payments are allowed on an interest-only loan, and Negatively-amortizing payments are allowed on a negative amortization loan The Official Interpretations address another issue that may arise when calculating the fullyindexed rate: the issue of interest rate adjustment caps. ARMs may have periodic rate adjustment caps to limit the amount that the interest rate may increase or decrease from one adjustment period to the next. The CFPB states that if a loan agreement includes a periodic interest rate adjustment cap, the creditor must not give any effect to that cap in determining the fully-indexed rate. 7 The creditor must therefore disregard any lower rate that may adjust for a periodic rate cap, and calculate the fully-indexed rate as if there were no cap in the agreement. Qualified mortgages, discussed in a later section of this course, are not subject to this restriction, and periodic rate caps can be considered when assessing repayment ability. ARMs may also have a lifetime cap, which limits the total amount that the interest rate can adjust over the life of the mortgage. Creditors are allowed to consider a lifetime maximum interest rate when calculating the fully-indexed rate FR 6450 (Jan. 30, 2013) 6 78 FR 6456 (Jan. 30, 2013) 7 Official Interpretations, 43(b)(3) 3. Interest rate adjustment caps 8 Official Interpretations, 43(b)(3) 4. Lifetime maximum interest rate 9

10 Finally, the Official Interpretations address calculating the fully-indexed rate for step-rate mortgages. The change in the interest rate for these loans is not based on an index or formula, and the maximum interest rate is established in the lending agreement. When calculating monthly payments to determine the repayment ability of consumers applying for step-rate mortgages, the creditor is required to use the maximum interest rate that would apply during the loan term. 9 The CFPB provides the example of a step-rate mortgage with an interest rate of 6.5% for the first two years, 7% the next three years, and 7.5% for the remainder of the loan term. In this example, the creditor must use the 7.5% interest rate for purposes of determining repayment ability. Definitions (12 C.F.R (b)) In order to gain a complete understanding of the scope of the Rule, it is necessary to know the meaning of the terms used in its provisions. Key terms of the ATR Rule are defined as follows: Covered transaction: a consumer credit transaction secured by a dwelling, other than an openend home equity line of credit, a mortgage related to a timeshare plan, a reverse mortgage, or a bridge loan of 12 months or less. Fully-amortizing payments: periodic payments that include sufficient principal and interest to fully repay the loan amount over the loan term. Maximum loan amount: this is a term that is relevant in transactions that result in negative amortization. The maximum loan amount is the amount of the loan plus any increase in principal that may result from negative amortization. This amount is calculated by assuming that the consumer makes the minimum periodic payments for the maximum period of time and that the maximum interest rate is reached at the earliest possible time. Mortgage-related obligations: these are defined to include property taxes, fees and special assessments imposed by a condominium, cooperative, or homeowners association, and premiums for insurance products required by the creditor, such as homeowners insurance, credit insurance, and charges for debt cancellation or suspension coverage. Simultaneous loan: this term refers to practices like piggyback lending. It specifically refers to another covered transaction, and to open-end equity lines of credit that are: Secured by the same dwelling, and Made to the same consumer at the same time or before the closing on the covered transaction, or made after the closing to cover the closing costs of the first transaction In its Official Interpretations, the CFPB clarifies that the term same consumer includes situations in which two or more consumers complete a covered transaction, after only one of these consumers has entered a separate prior transaction secured by the same dwelling. The 9 Official Interpretations, 43(b)(3) 5. Step-rate ad fixed-rate mortgages 10

11 payments related to this separate transaction, though entered into by only one of the consumers, must be included in the assessment of repayment ability. 10 Third-party record: documents or records that were reviewed or prepared by an appropriately qualified person other than the consumer, the creditor, or the mortgage broker, or an agent of the creditor or broker (12 C.F.R (b)(13)). The term third-party record is further defined to include specific documents, such as federal and state tax returns. The Official Interpretations of the CFPB further clarify that if a creditor gives a form to a third party, such as the loan applicant s employer, after completing portions of the form with identifying information, such as the loan applicant s name or creditor s name, the form is still regarded as a third-party record. 11 Basis for Determining Repayment Ability (12 C.F.R (c)(2)) There are eight factors that creditors are required to consider during the process of evaluating a consumer s ability to repay a loan according to its terms. The eight factors that must serve as the basis for this determination include the consumer s: Current or reasonably-expected income or assets, other than the value of the dwelling and any real property attached to it Employment status, if the creditor is relying on income from employment to determine repayment ability Monthly payments on the loan, calculated in accordance with provisions of the Rule The amount of the consumer s payment on any simultaneous loan known to the creditor Monthly payments for mortgage-related obligations Debt obligations, including alimony and child support Monthly debt-to-income ratio or residual income, calculated in accordance with provisions of the Rule, and Credit history As discussed at greater length in the section on payment calculation, the general rule for calculation is that payments on the loan that a consumer is seeking to secure must be made using: The fully-indexed rate or introductory interest rate, whichever is greater, and Monthly, fully-amortizing payments that are substantially equal (12 C.F.R (c)(5)) Verification of Information (12 C.F.R (c)(3); (4)) The ATR Rule requires verification of the information relied on by the creditor in determining repayment ability. This verification must be based on reasonably reliable third-party records (12 10 Official Interpretations 43(b)(12) Simultaneous Loans 11 Official Interpretations 43 (b)(13) 11

12 C.F.R (c)(3)). The Rule provides numerous examples of records that creditors may use to verify the income of a loan applicant. These examples include: Tax return transcripts issued by the IRS Copies of federal or state tax returns filed by the consumer Payroll statements Financial institution records Records from the consumer s employer Records from federal, state, or local government agencies showing benefits or entitlements received by the consumer Receipts from the consumer s use of check-cashing services, and Receipts from the consumer s use of a funds transfer service Although the Rule requires verification of most information using third-party documents, it allows creditors to verbally verify the employment status of a loan applicant, if they prepare a record of the verbal verification (12 C.F.R (c)(3)(ii)). Calculating Monthly Payments (12 C.F.R (c)(5); (6)) Monthly payments are one of the eight factors that creditors must consider in the evaluation on a consumer s ability to repay. Creditors must calculate monthly payments for a covered transaction based on: The fully-indexed rate or any introductory rate, whichever is greater, and Monthly, fully-amortizing payments, which are substantially equal The general rule for monthly payment calculations applies to most of the lending transactions that are likely to take place in the current and more conservative lending environment. If creative lending ever makes a comeback as a common financing strategy for getting consumers into homes, creditors must follow special payment calculation rules for interest-only loans, negative amortization loans, and loans that include a balloon payment. The following is a list of the payment calculation rules for non-standard loans: Balloon payment loans: for loans with a balloon feature, the monthly payment calculation must be based on the maximum payment that is scheduled during the first five years after the first regular periodic payment is due. A regular periodic payment is one that does not result in an increase of the principal amount. 12 The method used for calculating monthly payments differs for balloon payment loans in higher-priced covered transactions. For higher-priced mortgages with a balloon feature, the monthly payment calculation must be based on the maximum payment in the schedule, including any existing balloon payment (12 C.F.R (c)(d)(5)(ii)). 12 Official Interpretations 43(d)(1)(ii)(A) 1. Regular periodic payments 12

13 Interest-only loans: for interest-only loans, the monthly payment calculation must be based on the fully-indexed rate or any introductory interest rate, whichever is greater, and substantially equal monthly payments that will pay off the loan by the end of the term that remains after the loan is recast. Negative amortization loans: for negative amortization loans, the monthly payment calculation must be based on the fully-indexed rate or any introductory interest rate, whichever is greater, and substantially equal monthly payments that will pay off the maximum loan amount by the end of the term that remains after the loan is recast. There is also a special rule regarding the monthly payment calculation for simultaneous loans. In calculating these payments, creditors must use the rules outlined above. However, if the simultaneous loan is an open-end home equity line of credit, the creditor must consider the periodic payment required by the terms of the loan and the amount of credit to be drawn at or before consummation (12 C.F.R (c)(6)(ii)). There may be a few circumstances in which a consumer would want a nontraditional loan, such as an interest-only or a negative amortization loan, or one with a balloon payment feature. Most of these circumstances are likely to involve the borrower s short-term interest in the dwelling securing the loan. However, even in these circumstances, the loan applicant must qualify based on his or her ability to make amortizing payments at the fully-indexed rate. These rules therefore eliminate future transactions in which loan applicants will seek to qualify for a nontraditional mortgage based solely on their ability to meet an initial low monthly payment. Calculating Debt-to-Income Ratios or Residual Income (12 C.F.R (c)(7)) The monthly debt-to-income ratio (also referred to in the Rule as residual income ) is one of the eight factors that creditors must consider in the evaluation of a consumer s ability to repay. When calculating a consumer s monthly debt-to-income ratio, creditors must consider the ratio of the consumer s total monthly debt to his or her total monthly income. Total monthly debt is defined to include the sum of monthly payments on the loan sought, any simultaneous loans, mortgage-related obligations, as the Rule defines them, and any other monthly obligations, including alimony and child support. Total monthly income is defined to include the consumer s verified current or reasonably-expected income, plus income from verified assets. In its Official Interpretations of the Rule, the CFPB clarifies what might constitute reasonablyexpected income. The CFPB states that if a creditor relies on expected income as a basis for evaluating repayment ability, the income must be reasonable and properly verified through thirdparty records that give reasonably reliable evidence of the consumer s expected income. 13 Examples of reasonably-expected income cited by the CFPB include an expected annual bonus that bears a reasonable relationship to bonuses earned in the past, or an expected salary, verified in writing, from a job that the consumer has accepted. 13 Official Interpretations 43(c)(2)(i) 3. Reasonably expected income 13

14 Creditors have the option of considering a consumer s residual income, which is calculated by subtracting the consumer s total monthly debt obligations from his or her total monthly income. There is an important difference between the provisions that address debt-to-income ratios in the ATR Rule and those in the section of the Rule referring specifically to qualified mortgages. The QM Rule states that a qualified mortgage is a covered transaction for which the consumer s total monthly debt-to-income ratio at consummation does not exceed 43% (12 C.F.R (e)(2)(vi)). The presence of these two sets of underwriting requirements is based on statutory provisions found in the Dodd-Frank Act. These provisions reflect Congress s intent to encourage creditors to make qualified mortgages without discouraging the origination of other types of loans for consumers who cannot satisfy the debt-to-income ratio requirement for qualified mortgages. Other important differences in these standards will be discussed in a later section. Record Retention (12 C.F.R (c)(3)) Creditors must retain records to show compliance with the ATR Rule for three years after consummation of a covered transaction. In its Official Interpretation of the Rule, the CFPB explains that the retention of paper copies is not required. However, the creditor must be able to accurately reproduce those records. 14 As an example, the CFPB states that if a creditor uses a W-2 form to verify income, the creditor must be able to reproduce the form itself, and not simply the information contained in the form. Discussion Scenario: Determining Repayment Ability Athena is a loan originator for a mortgage banker that originates loans for several large creditors. She is working with a young dentist named Sarah, who has found a dream home near her office. Sarah is shopping for a mortgage that will allow her to make low monthly payments on her new home while she builds her dental practice. The home is listed for $300,000, which is a fair market price. Sarah has read about 5/1 ARMs, and believes that this loan product will meet her needs. When Sarah completes an online loan application, she indicates that her annual salary is $95,000, and that she has $10,000 for a down payment. Athena advises Sarah that she is not likely to meet creditor underwriting requirements without a substantially larger down payment. However, believing that this home would suit all of her needs for many years to come, Sarah insists that she wants to pursue the application. In a follow-up meeting, she brings a copy of her last two tax returns, recent statements from her checking and savings accounts, and a quarterly statement showing the value of some modest investments she has made through a stockbroker. Sarah also asks Athena to look at calculations she has completed which show that, at the current rate at which her practice is growing, she should be earning $150,000 in two years. Athena works with two creditors that offer a standard 5/1 ARM to qualified borrowers with an interest rate of 2.5% for the first five years of the loan term. After the loan is recast, future 14 Official Interpretations page 25 (a) 2. Methods of retaining evidence 14

15 interest rates will be based on a six-month LIBOR plus a 3% margin. At Sarah s insistence, she submits the application to one of the creditors, including information on Sarah s projected earnings in two years. Discussion Questions What are the underwriting factors that the creditor will consider while evaluating Sarah s application? How will the creditor determine if Sarah will have the ability to meet her monthly payments? Is a 5/1 ARM a good loan product for Sarah? Can Sarah use her reasonably-expected future income to qualify for the loan? In addition to the information that Sarah has offered on her income and assets, what is some additional information that the creditor will consider in underwriting Sarah s loan? If Sarah does not qualify for a 5/1 ARM, would other products, such as an interest-only loan, be a better option for her? If Athena cannot secure a loan that will enable Sarah to purchase the home, would it make sense for Sarah to seek an additional loan from another broker or lender? Discussion Analysis Assuming that this transaction is taking place after the January 2014 effective date for the ATR Rule, the new provisions of this rule will dictate how Sarah s repayment ability is determined. There are eight underwriting factors that the creditor will consider: Sarah s current or reasonably expected income or assets, her employment status, her monthly mortgage payments on the loan, monthly payments on any simultaneous loans, monthly mortgage-related payments, current debt obligations, her monthly debt-to-income ratio, and her credit history. Under the ATR Rule, the creditor must determine Sarah s ability to meet her monthly mortgage payments based on the fully-indexed rate. This means that the creditor must calculate the interest rate by adding: An index that will apply after the introductory fixed rate expires, using the rate that is current at the time that the loan is consummated, and The 3% margin that is stated in the note For example, if the LIBOR on the date of consummation is 4%, then the fully-indexed rate for purposes of determining repayment ability is 7%. A 5/1 ARM would be a good product for Sarah if she could qualify for it, since it would allow her to make low monthly payments while she is establishing her dental practice. However, as a result of the ATR Rule, Sarah cannot qualify for the loan based on the initial low monthly payments, and must instead qualify based on her ability to make payments at the fully-indexed rate. She is unlikely to be able to do this. If Sarah had a higher income or a much larger down 15

16 payment and could, therefore, qualify at the fully-indexed rate, the suitability of the 5/1 loan would be important to consider. In this situation, Athena could help Sarah to determine if the lower payments on the 5/1 ARM would outweigh the benefits of locking in a low fixed rate at the beginning of the loan term. This is a particularly appropriate conversation, given that Sarah has found a home that she would like to purchase and stay in for many years. Although Sarah may have a sound analysis for assuming that her reasonably-expected income will be $150,000, the CFPB s Official Interpretations of the ATR Rule state that expected income must be verified by third-party records providing reasonably reliable evidence of the expected income. Even if Sarah s income projections were calculated by a third party, such as an accountant, it is unlikely that the creditor would rely on them, since the CFPB s descriptions of expected income are tangible, and not theoretical. In addition to the information that Athena has already obtained from Sarah, she needs Sarah s credit history, debt obligations, monthly debt-to-income ratio, and payments on any simultaneous loans. If Sarah does not qualify for a 5/1 ARM, she is not likely to qualify for other nontraditional products, such as an interest-only or a negative amortization loan. When applying for these loans, she will still need to qualify based on her ability to make fully-amortizing monthly payments at either the loan s fully-indexed rate or its introductory rate, whichever is higher. The ATR Rule discourages simultaneous or piggyback loans by requiring creditors to consider the amount of the consumer s payment on any simultaneous loan that is known to the creditor. If Sarah went to a separate creditor to obtain additional funds to be secured by the dwelling, she would have to disclose both loans on her mortgage applications or risk prosecution for fraud and misrepresentation. Refinancing of Hybrid Loans (12 C.F.R (d)) As directed by the Dodd-Frank Act, the ATR Rule exempts creditors from performing a full repayment analysis when refinancing a potentially unaffordable hybrid or non-standard mortgage with a standard mortgage. The CFPB explains that this exemption was created to enable creditors to offer a new loan with lower monthly payments to consumers facing increased payments due to the recast of a loan, without forcing the creditor to go through the full underwriting process. 15 In the Preamble to the ATR Rule, the CFPB unofficially refers to the refinancing of non-standard mortgages to standard mortgages as payment shock refinancings. The more flexible or streamlined underwriting standards for a payment shock refinancing are outlined below. Note that this section of the law includes its own set of definitions, as well as its own method for calculating monthly mortgage payments FR 6489 (Jan. 30, 2013) 16

17 Definitions The terms used in the Dodd-Frank Act to identify those loans that are suitable for payment shock refinancings are different from those used in the regulations. The law addresses the refinancing of hybrid loans with standard loans, but does not define either of these terms. The implementing regulations change the terms found in the law, substituting the term hybrid loan with the term non-standard mortgage, and the term standard loan with standard mortgage. 16 The Final Rule provides the following definitions of these terms: Non-standard mortgage: a covered transaction that is: o An adjustable-rate mortgage with an introductory fixed interest rate of one year or more o An interest-only loan, or o A negative amortization loan Standard mortgage: a covered transaction that meets each of the following characteristics: o A repayment schedule that does not allow the principal balance to increase, that does not allow the consumer to defer repayment of principal, and that will not result in a balloon payment o Total points and fees do not exceed 3% of the total loan amount for loans in the amount of $100,000 or more (other caps apply for loans of less than $100,000) o The loan s term will not exceed 40 years o The interest rate is fixed for at least the first five years after consummation, and o The loan proceeds are used solely for the purpose of paying off the outstanding balance on the non-standard mortgage and paying settlement and closing costs In its Official Interpretations, the CFPB emphasizes that a loan does not meet the requirements for a payment shock refinancing if the proceeds are used for any purpose other than the permissible uses, which are limited to paying off the non-standard mortgage and paying closing costs. Cash-out refinances are not included. Scope of the Refinancing Provisions (12 C.F.R (d)(2)) Relief from the burden of performing a full repayment analysis applies in a limited number of refinancings. In order for a payment shock refinancing to occur, each one of the following conditions must be met: The refinancing will be provided by the creditor that is currently holding the existing non-standard mortgage, or by the current loan servicer acting on the creditor s behalf The monthly payment on a new standard mortgage will be materially lower than the monthly payment on the non-standard mortgage 16 Ibid. 17

18 The creditor receives the borrower s application for a refinancing no later than two months after the non-standard mortgage is recast The borrower has made no more than one payment that is more than 30 days late on the non-standard mortgage during the 12 months immediately preceding the creditor s receipt of a written application to refinance the non-standard mortgage with a standard one, and The borrower has made no payments that are more than 30 days late during the six months immediately preceding the creditor s receipt of a written application to refinance the non-standard mortgage with a standard one For non-standard mortgages consummated on or after January 10, 2014, there is an additional condition that must be met in order for the refinancing to be made without a complete underwriting analysis: the non-standard mortgage that the consumer is attempting to refinance must have been subject to an analysis of repayment ability or must be a qualified mortgage; otherwise, a complete ability-to-repay analysis will be required. Calculating and Comparing Payments of Non-Standard and Standard Mortgages A creditor may not refinance a non-standard mortgage with a standard one unless the new loan will result in materially lower payments. In order to determine whether the refinancing will result in materially lower payments, creditors must compare the monthly periodic payments of the existing non-standard mortgage and those of a new standard mortgage. Payments are calculated and compared as follows: Payments for standard mortgages: the monthly payments for the standard mortgage must be based on substantially equal, fully-amortizing monthly payments based on the maximum interest rate that may apply during the first five years after consummation (12 C.F.R (d)(5)(ii)). Payments for non-standard mortgages: payments for a non-standard mortgage must be based on substantially equal, fully-amortizing monthly payments, including payments of principal and interest, but there are a number of specific rules regarding the calculation of these payments. Calculation of payments must consider: o A fully-indexed interest rate calculated within a reasonable period of time before or after the creditor receives the consumer s application for a standard mortgage. The CFPB clarifies that a reasonable period is generally 30 days. 17 o The loan term remaining on the date that the recast occurs. o The remaining loan amount, which is calculated differently depending on the type of non-standard mortgage that the consumer wants to refinance. For nonstandard adjustable-rate mortgages and interest-only loans, the remaining loan amount is the principal balance remaining on the date of the recast, assuming that the borrower has made all scheduled payments up to that point and that the most recent payment has been credited. For negative amortization loans, the principal 17 Official Interpretations 43 (d)(5)(i) 2. Fully indexed rate 18

19 remaining loan amount is the maximum loan amount, which is the loan amount plus any increase in the principal due to negative amortization. The regulations do not state that a payment must be reduced by any particular percentage or amount. In its Official Interpretations, the CFPB states that whether an amount is materially lower will depend on the facts and circumstances of each case. However, the Commentary also provides a very useful guideline for knowing when a payment on a standard mortgage is materially lower than the payment on the existing mortgage, stating that a payment reduction of 10% or more meets this standard in all cases. 18 Determining if the Exemption Applies (12 C.F.R (d)(3)) In order to determine if a creditor is exempt from the (c) requirements to assess borrower repayment ability, creditors must: Make certain that the transaction meets all of the criteria to fall within the scope of the payment shock refinancing exemption, and Consider whether the standard loan is likely to prevent a default by the consumer on the non-standard mortgage after recast If the creditor is exempt, it may offer the consumer rate discounts or terms that are the same as or better than those offered to new consumers, consistent with the creditor s documented underwriting practices (12 C.F.R (d)(4)). The Official Interpretation offers the following example to illustrate the meaning of this provision: assume that a creditor is providing a consumer with a [payment shock]refinancing and that this creditor has a documented practice of offering rate discounts to consumers with credit scores above a certain threshold. Assume further that the consumer receiving the refinancing has a credit score below the threshold, and therefore would not normally qualify for the rate discount available to consumers with high credit scores. This creditor complies with Section (d)(4) [of the rule] by offering the consumer the discounted rate in connection with the refinancing even if the consumer would not normally qualify for the discounted rate, provided the offer of the discounted rate is not prohibited by applicable State or Federal law. 19 It remains to be seen if creditors will respond to the incentives that these provisions offer for refinancing non-standard loans that may result in defaults. Discussion Scenario: Ability-to-Repay Exemption for Refinancing a Non-Standard Mortgage On February 15, 2014, Josh closes on a 2/1 ARM to purchase his first home. Although he faces some financial challenges after moving into his house, he makes only one payment that is more than 30 days late, making his July 1, 2015 payment in mid-august of that year. Two weeks after 18 Official Interpretations 43(d)(2) 1. Materially lower 19 Official Interpretations 43(d)(4) 1. Documented underwriting practices 19