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A new set of federal rules will eventually limit the use of low-documentation and no-documentation mortgage loans. Under the new rules, which are scheduled to take effect in January 2014, mortgage lenders must thoroughly review and document a borrower’s ability to repay the loan obligation. This Ability-to-Repay rule will effectively prohibit the use of “low-doc” and “no-doc” mortgages.

The Rise and Fall of No-Doc / Low-Doc Loans

During the housing boom of the early to mid 2000s, a borrower could qualify for a mortgage loan with little to no documentation. Most lenders, for example, offered stated-income loans that allowed borrowers to verbally declare their earnings and income. No supporting documents were required. Those were the days of lax regulation and easy credit, the days when almost anyone could qualify for a home loan.

In 2006 and 2007, the Federal Reserve Board of Governors held hearings to discuss a variety of consumer-protection issues relating to the mortgage industry. In those hearings, a number of government officials and consumer groups shared their concerns about risky underwriting practices, such as the use of “stated income” and “low documentation” loans. These were scenarios where borrowers provided little or no documents to prove their income, assets and debts.

Today, low-doc and no-doc mortgages have been lumped into the category of high-risk “exotic” mortgages. Lenders shy away from them. Investors don’t want to buy them. And the federal government is attempting to squash them once and for all.

In the wake of the 2008 housing crisis, the government began looking for ways to limit the use of high-risk mortgage products, including low-doc and no-doc mortgages. These efforts were formalized in the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in 2010.

The Dodd-Frank Act introduced what is now known as the ability-to-repay rule. In short, it requires lenders to verify and document a borrower’s income, assets and debts. They must ensure the borrower has the financial means to repay the loan, based on the size of the monthly payments in relation to the borrower’s debt and income.

To recap: As a result of these new rules, no-documentation and low-documentation mortgages will soon become a thing of the past. They will be prohibited by the Ability-to-Repay rule, which was mandated by the Dodd-Frank Act and finalized by the Consumer Financial Protection Bureau (CFPB).

Today, High Documentation is the Name of the Game

In the current market, borrowers must provide a variety of documents when applying for a mortgage. This is the way it should be. We got away from this sensible verification process during the housing boom. Now we are getting back on track. Lenders are once more requiring sufficient documentation to verify income and earnings. In 2014, it will become the law.

Here’s an excerpt from the Ability-to-Repay fact sheet released by the CFPB earlier this month:

“Under the new Ability-to-Repay rule, lenders will have to determine the consumer’s ability to pay back both the principal and the interest over the long term … Lenders can no longer offer no-doc, low-doc loans, otherwise known as ‘Alt-A’ loans, where some lenders made quick sales by not requiring documentation…”

The language is clear. Unless the Ability-to-Repay rule is amended or altered between now and January 2014, it will effectively abolish the use of no-documentation and low-documentation mortgages. Such loans are expressly prohibited by the Ability-to-Repay rule. As stated on the CFPB website, mortgage lenders “generally must document” the following items:

  • The borrower’s employment status
  • The income and assets being used to qualify for the loan
  • The borrower’s current debt obligations (credit cards, car loans, etc.)
  • The borrower’s credit history
  • Monthly payments for all mortgage-related obligations

This list is not exhaustive, but merely represents the minimum requirement under the Ability-to-Repay provision. Some lenders will require much more in the way of documentation. The items shown above pertain to the borrower’s income and debt specifically.