Part 1 of a 2-part series.
Effective January 10, 2014
The CFPB has issued a final rule to implement sections 1411 and 1412 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which requires creditors, like credit unions, to make a reasonable, good faith determination of a consumer’s ability to repay any consumer credit transaction secured by a dwelling (excluding open-end credit plans, timeshare plans, reverse mortgages and temporary loans) and sets forth certain protections from liability for creditors under a new requirement for “qualified mortgages.”  This final rule also limits prepayment penalties and establishes a 3-year record retention rule to evidence compliance. The provisions of the rule are found in the new Truth in Lending Act (TILA) sections 129C and 130 and in sections 1026.25, 1026.32, and 1026.43 of Regulation Z and its Official Interpretations to these sections.

Ability-to-Repay, Section 1026.43(c)

Generally speaking, the new rule prohibits a creditor from making a mortgage loan unless the creditor first makes a reasonable and good faith determination, based on verified and documented information, that the consumer has a reasonable ability to repay the loan according to its terms and including all applicable taxes, insurance (required flood insurance premiums and premiums for coverage that protects the creditor against the consumer’s default or other credit loss) and other assessments.
While the final rule establishes certain minimum requirements for determining a consumer’s ability to repay, it does not dictate particular underwriting models.  At a minimum, creditors must consider eight underwriting factors:

  • Current or reasonably expected income or assets;
  • Current employment status;
  • Monthly payment on the covered transaction;
  • Monthly payment on any simultaneous loan (including the minimum payment for any funds extended through a HELOC);
  • Monthly payment for mortgage-related obligations;
  • Current debt obligations, alimony and child support;
  • Monthly debt-to-income ratio or residual income; and
  • Credit history (i.e. through the use of a credit report or nontraditional credit references, such as rental payment history or utility payments).

The Official Interpretation to section 1026.43(c)(1) states that the following factors may be relevant in determining whether a creditor considered and verified the required factors and arrived at a determination that was reasonable and in good faith:

  • The consumer demonstrated actual ability to repay the loan by making timely payments, without modification or accommodation, for a significant period of time after consummation;
  • The creditor used underwriting standards that have historically resulted in comparatively low rates of delinquency and default during adverse economic conditions; or
  • The creditor used underwriting standards based on empirically derived, demonstrably and statistically sound models.

On the other hand, the following factors might be evidence that the creditor’s ability to repay determination was not reasonable or in good faith:

  • The consumer defaults on the loan shortly after consummation;
  • The creditor used underwriting standards that have historically resulted in comparatively high levels of delinquency and default during adverse economic conditions;
  • The creditor applied underwriting standards inconsistently or used underwriting standards different from those used for similar loans without reasonable justification;
  • The creditor disregarded evidence that the underwriting standards it used are not effective at determining a consumer’s repayment ability;
  • The creditor consciously disregarded evidence that the consumer might have insufficient residual income to cover other obligations and expense; or
  • The creditor disregarded evidence that the consumer would have the ability to repay only if he/she subsequently refinanced the loan or sold the property securing the loan.

Income and Assets, Section 1026.43(c)(2)(i)

A creditor must consider the consumer’s current income, reasonably expected income and financial resources other than the value of the property securing the loan. The creditor may also take into consideration whether the income is seasonal or irregular in nature.  Appendix Q, which follows the provisions of Regulation Z, provides further information about the types of income and assets that may be used.
In general, creditors must use reasonably reliable third party records to verify the information they use to evaluate their underwriting factors.  A creditor only needs to verify income and assets relied on for qualification for repayment of the loan. So, if a consumer has a second job, but the creditor has not relied on the income from that second job to qualify the applicant, the creditor does not have to obtain documentation to verify the income from the second job.  A reliable third party record can include; (1)  a profit-and-loss statement prepared by a self-employed consumer as long as it’s reviewed by a third-party accountant;  and (2)  records the creditor maintains for the consumer’s account, such as account statements.  Section 1026.43(c)(4) provides examples of other reasonable methods that can be used to use to verify income and assets.

Employment, Section 1026.43(c)(2)(ii)

The creditor only needs to verify employment if the income from that employment will be used as a source of repayment for the loan.  Employment may be full-time, part-time, seasonal, irregular, military or self-employment.  The creditor can verify employment orally as long a record of the oral information is maintained.  Military employment can be verified using the electronic database maintained by the Department of Defense.

Monthly Payment Calculation, Section 1026.43(c)(5)

For the purpose of determining a consumer’s ability to repay, the creditor must consider the consumer’s monthly mortgage obligation.  This monthly payment must be calculated with the assumption that the loan will be repaid in substantially equal monthly payments during the term of the loan.  For adjustable-rate mortgages, the monthly payments must be calculated using the higher of the fully indexed rate or an introductory rate.  There are special calculation rules for loans with balloon payments, interest-only payments or negative amortization situations.

Refinancing of “Non-Standard” Mortgages, Section 1043(d)(3)

Two provisions of the Dodd-Frank Act address the refinancing of existing mortgage loans under the ability-to-repay requirements.  These sections are designed to encourage creditors to refinance existing “hybrid” or “non-standard” loans (but not balloon-payment mortgages) into “standard loans” by allowing for greater flexibility when complying with the general ability to repay provisions.   These refinancing offers are to be made available to consumers who are likely to default when the “hybrid” or “non-standard” loan is recast.  As such, section 1026.43(d)(3) provides an exemption to the general ability-to-repay requirements if these additional following conditions are met:

  • The creditor of the “standard” mortgage must be the same as the creditor for the “non-standard” mortgage (or the servicer acting on behalf of the current creditor);
  • The monthly payment on the “standard” mortgage must be materially lower than the monthly payment for the “non-standard” mortgage;
  • The creditor must receive the consumer’s written application no later than two months after the “non-standard” mortgage has recast, provided certain other conditions have been met;
  • The consumer has made no more than one payment more than 30 days late on the “non-standard” mortgage during the 12 months immediately preceding the creditor’s receipt of the consumer’s written application for the”standard” mortgage; and
  • The consumer has made no payments more than 30 days late during the six months immediately preceding the creditor’s receipt of the consumer’s written application for the “standard” mortgage.

Note that if the original “non-standard” loan is consummated on or after the effective date of this rule, the “non-standard” loan must have been originated in accordance with the section 1026.43(c) ability-to-repay requirements.
A “standard” mortgage is defined as a mortgage where:

  • The regular periodic payments do not: (1) cause the principal balance to increase; (2) allow the consumer to defer repayment of the principal; or (3) result in a balloon payment;
  • The total points and fees payable in connection with the transaction do not exceed the thresholds in section 1026.43(e)(3);
  • The loan term does not exceed 40 years;
  • The interest rate is fixed for the first five years after consummation (5/1 ARMS are acceptable); and
  • The proceeds from the loan are used solely to pay off the outstanding principal balance on the non-standard mortgage and pay the closing costs and any required escrow deposits.

Keep in mind that a reduction in the APR with a corresponding change in the payment schedule  is generally not considered a “refinancing” and is, therefore, not subject to the ability-to-repay requirements.  See section 1026.20(a) for more information.