Many Lenders Were Ahead of New Mortgage Rules

Published January 14, 2014

The Consumer Financial Protection Bureau’s new qualified mortgage stipulations, including the “ability-to-repay” rule, went into effect January 10, legally putting into effect some of the requirements lenders had already put into place on their own.

The ability-to-repay rule requires creditors to show a person’s ability to repay the loan. The rule generally requires a borrower’s debt-to-income ratio (including other loans, credit card debt, etc., not just the mortgage) not exceed 43 percent of earnings. Although this may seem like common sense, it was often overlooked during the real estate and mortgage boom of the 2000s and became a factor in the financial crash that followed, said Michael G. Barone, partner in charge of the mortgage compliance department of the law firm Abrams Garfinkel Margolis Bergson, LLP, in New York.

The latest rules “put pen to paper” for what the industry was already doing on its own, Barone said. “I don’t think there will be a big effect from the ability-to-repay rule.”

But the law does provide the borrower some legal protection if the lender doesn’t follow the rule and the borrower later defaults, Barone added.

No More Interest-Only Loans

Beyond making sure borrowers have adequate resources to repay their loans, the new rules also eliminate loans allowing for interest-only payments or negative amortization, under both of which approaches the loan repayment amount rises in subsequent months. Under the interest-only payments, a borrower would pay just the interest and no principal. The monthly payment would increase because the borrower would have less time to repay the loan even as the principal amount remained the same. These loans, like “liar loans,” quickly went into default when real estate prices started falling.

During the real estate boom, there were plenty of “liar loans,” which took two basic forms–one in which the borrower would lie about his or her income, and the other in which the broker or lender would falsify the amount of income so the borrower could qualify for the loan (and the lender or broker could receive a commission on it).

Such practices mattered little when real estate prices kept rising, because borrowers could gain equity to cover the shortfall in income or sell the property before any shortfall became a problem. When real estate prices started falling, however, many borrowers couldn’t make their payments, borrow more money against the property, or sell the property. This led to defaults.

As a result, many of the brokers and lenders who either knowingly falsified documents or were lax in their verification went out of business.

Ahead of Regulators

Most of those who stayed in business had already strengthened their processes for verifying income and ability to repay–requiring transcripts of federal income taxes rather than tax returns, calling employers to verify employment, requiring current check stubs, tightening credit score requirements, and taking other precautions to try to minimize the risk of the mortgages.

Theoretically, lenders can still make loans that don’t meet the new guidelines. But they would have to guarantee those loans themselves, and they wouldn’t be able to sell them into the secondary market, which provides most of the credit for lending.

The new verification procedures have slowed the process of qualifying and closing loans. During the real estate boom the process sometimes took as little as two weeks. Now a month to six weeks is much more common. Appraisals also are generally much more conservative than they once were. That means borrowers typically have to make higher down payments to qualify for mortgages.

Another part of the qualified mortgage rules impacting the industry, particularly mortgage brokers, is the stipulation that upfront fees for a loan may not exceed 3 percent, according to Barone. This hurts mortgage brokers in particular because, since the end of the real estate boom, they have been closing few loans. So they have relied on additional fees from title services, appraisals, and other ancillary services to make ends meet. With the new rules, anyone with these ancillary businesses has been forced to sell them so as not to exceed the 3 percent cap.