On May 11, 2011, the Federal Reserve Board (FRB) issued a proposed rule (Rule) to implement ability-to-repay requirements for closed-end residential loans.[i] The Rule implements Section 1411, Section 1412, and part of Section 1414 of the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act of 2010 (Dodd-Frank).[ii] Comments on the Rule are to be received by no later than July 22, 2011.[iii] Having published the proposed Rule, the FRB retired from its involvement in this matter and handed over its rulemaking authority in the subject statute to the Consumer Financial Protection Bureau (CFPB) on July 21, 2011.[iv]
As a revision to Regulation Z (the implementing regulation of the Truth in Lending Act), the Rule requires creditors to determine a consumer’s ability to repay a mortgage before making the loan and would also establish minimum mortgage underwriting standards. The Rule applies to any consumer credit transaction secured by a dwelling, except an open-end credit plan, timeshare plan, reverse mortgage, or temporary loan or ‘‘bridge’’ loan with a term of 12 months or less. [v] It appears that the Rule applies to purchase money and refinances, but not modifications of existing mortgages. There is a prohibition on prepayment penalties unless the mortgage is a prime, fixed rate, qualified mortgage - and unless the amount of the prepayment penalty is limited.
The Rule sets forth limits on prepayment penalties, the lengthening of the time creditors must retain records evidencing compliance with the ability-to-repay and prepayment penalty provisions, a prohibition to evading the Rule by structuring a closed-end extension of credit as an open-end plan, the delineation of new terms, procedures, and their resulting implications, and, very importantly, the means by which the Rule claims to offer tools to prevent likely default and mitigate risk for creditors and others who arrange, negotiate, or obtain an extension of mortgage credit for a consumer in return for compensation or other monetary gain.
Complying with the requirements of the ability-to-repay Rule is essential, because borrowers in a foreclosure proceeding will likely claim that the creditor failed to comply with the Rule as a defense by way of recoupment or set off, without regard to the normal statute of limitations under the Truth-in-Lending Act (TILA).[vi] A violation of the Rule subjects the creditor to the TILA civil monetary penalties, plus the same enhanced civil remedies that apply to violations of TILA’s high-cost loan rules,[vii] and TILA also would authorize state attorneys general to bring actions for violations of the Rule for a period of up to three years.[viii]
A loan that is a covered transaction must qualify, among other things, as a “qualified mortgage” if the creditor wishes to include a prepayment penalty in the loan.
The Rule provides a presumption of compliance with the ability-to-repay requirements if the mortgage loan is a ‘‘qualified mortgage,’’ which does not contain certain risky features and limits points and fees on the loan. Furthermore, one feature of a higher-risk mortgage loan (i.e., subject to enhanced appraisal requirements under Dodd-Frank § 1471) is the loan may not be a qualified mortgage.[ix]
There are four (4) options to the determination of compliance with the Rule. The Rule refers to these origination options as “methods” and equips each method with a description of (1) limits on the loan features or term, (2) limits on points and fees, (3) underwriting requirements, and (4) payment calculations.
Option # 1: General Ability-to-Repay Standard
A creditor can meet the general ability-to-repay standard or test by:
- Considering and verifying the following eight (8) underwriting factors:
1. Income or assets relied upon in making the ability-to-repay determination;
2. Current employment status;
3. The monthly payment on the mortgage;
4. The monthly payment on any simultaneous mortgage;
5. The monthly payment for mortgage-related obligations;
6. Current debt obligations;
7. The monthly debt-to-income ratio, or residual income; and
8. Credit history.
- Underwriting the payment for an adjustable-rate mortgage based on the fully indexed rate.
Comment: This is an option that will be carefully reviewed by plaintiff’s counsel in an action to challenge a creditor’s compliance with the Rule. Consequently, enforcing compliance with the Rule will require fully vetted, tested, and continually updated, written procedures to govern every aspect of the application and underwriting process. Without clear and unambiguous policies and internal enforcement of appropriate policies and procedures, the creditor is allowing exposure to such a challenge. This option contains rigorous underwriting criteria and requires unmitigated, fact-based evaluations. Option # 1- the ability-to-repay test - is somewhat unstable (due to the invariant rigors of procedural compliance) though a relatively favorable methodology for the creditor, even if the loan flow process leaves very little room for error.
Option # 2: Qualified Mortgage (QM)
A creditor can originate a “qualified mortgage,” which provides special protection from liability. Two alternative definitions of a “qualified mortgage” are being considered by the CFPB:
Alternative # 1: Provides a legal safe harbor and defines a “qualified mortgage” as a mortgage for which:
· The loan does not contain negative amortization, interest-only payments, or a balloon payment, or a loan term exceeding 30 years;
· The total points and fees do not exceed three (3%) percent of the total loan amount;
· The income or assets relied upon in making the ability-to-repay determination are considered and verified;[x] and,
· The underwriting of the mortgage (a) is based on the maximum interest rate that may apply in the first five years, (b) uses a payment scheduled that fully amortizes the loan over the loan term, and (c) takes into account any mortgage-related obligations.
Alternative # 2: Provides a rebuttable presumption of compliance and would define a “qualified mortgage” as including the criteria listed under Alternative # 1 (above) as well as additional underwriting requirements from the general ability-to-repay standard (see Option # 1). In any event, under Alternative # 2, the creditor would also have to consider and verify:
· The consumer’s employment status;
· The monthly payment for any simultaneous mortgage;
· The consumer’s current debt obligations;
· The monthly debt-to-income ratio or residual income; and
· The consumer’s credit history.
Comment: Two alternatives are given: in Alternative # 1, to obtain a legal safe harbor, the creditor must consider and verify the borrower’s current or reasonably expected income or assets to determine the borrower’s repayment ability; and, in Alternative # 2, to obtain a rebuttable presumption of compliance, the creditor must consider and verify the borrower’s current or reasonably expected income or assets (i.e., other than the value of the dwelling in question), the borrower’s current employment status (assuming the creditor relies on employment income), the borrower’s monthly payment on any simultaneous loan, the borrower’s current debt obligations, the borrower’s monthly DTI or residual income, and the borrower’s credit history. It should be noted that the second alternative is for the most part similar to the ability-to-repay test.
