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In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. The Dodd-Frank Act aims to reform the U.S. financial industry, in order to prevent a recurrence of the 2008 housing and financial crisis. Among other things, this act required the creation of new rules for the mortgage industry. The so-called ‘Ability to Repay’ rule is one of those new requirements, and it will affect the ways loans are generated in the U.S.

Background and Overview

During the housing boom that preceded the recent U.S. financial crisis, lenders frequently gave mortgage loans to borrowers who realistically could not afford them. This was often done through the use of “low-doc” and “no-doc” loans with little or no documentation. It is now widely accepted that such practices contributed to the housing and mortgage collapse of 2007 - 2008. The Ability-to-Repay rule is designed to prevent a recurrence of such events. This rule will take effect in January 2014.

Key concepts of the new rule:

  • Mortgage borrowers must provide ample financial documentation; lenders must verify the documents.
  • In order to be approved for a particular home loan, the borrower must have sufficient income and assets to repay the loan.
  • Lenders must measure the borrower’s ability to repay the principal and interest over the long term, not just during an introductory period when the rate might be lower.

The Ability-to-Repay rule protects consumers from taking on mortgages that exceed their financial means, by mandating the documentation / proof of income and assets.
According to CFPB director Richard Cordray: “We believe this rule does exactly what it is supposed to do: It protects consumers and helps strengthen the housing market by rooting out reckless and unsustainable lending, while enabling safer lending.”

Final Version of the Ability-to-Repay Rule

You must have the financial means to repay your mortgage obligation, at the time of origination. The lender must ensure you can repay the loan by reviewing certain financial documents (bank statements, tax records, etc.). This is the core concept behind the CFPB’s new Ability-to-Repay rule.

Financial documents must be provided and verified: Under the new rules, mortgage lenders will be required to examine and verify a borrower’s financial documents. At a minimum, lenders must look at eight underwriting items:

  1. Credit history
  2. Current employment status
  3. Current income or assets
  4. Monthly payment for the home loan
  5. Monthly payments on other loans related to the property (such as a second mortgage)
  6. Monthly cost of other mortgage-related obligations (such as property taxes)
  7. Other debts the borrower has (credit cards, car payments, etc.)
  8. Monthly debt-to-income ratio, or residual income after all monthly debts have been paid

Borrowers must be able to repay the mortgage: When considering applicants, lenders must ensure that a borrower has the ability to pay back the loan. They must do this by reviewing the borrower’s available income and assets. By extension, this means the applicant must provide certain documents that show income and assets. These documents include, but are not limited to, bank statements, IRS W-2 forms, tax returns, payroll statements, and the like.

Deceptive ‘teaser rates’ are prohibited: The mortgage rate shown to a borrower cannot mask the true cost of the loan. Additionally, mortgage lenders cannot measure the borrower’s ability to repay the loan based on a teaser rate. (A teaser rate is an introductory interest rate that is lower than the long-term rate. They are typically associated with adjustable-rate mortgage loans.) Lenders must measure the borrower’s ability to repay the mortgage over the long term.

Exemptions for refinance loans: Exceptions to these rules can be made for homeowners who are trying to refinance out of a risky mortgage and into a more stable loan. According to the CFPB, the term ‘risky’ can refer to loans with interest-only payments, adjustable interest rates, or negative-amortization features (where the principal balance grows over time). Lenders that are refinancing a homeowner into a more stable, standard mortgage can do so without going through the extensive underwriting procedures required by the ability-to-repay rule.

The Ability-to-Repay rule is the first of several steps taken by the CFPB to encourage safer lending in the United States. The ultimate goal is to prevent a recurrence of the mortgage and housing crisis that drove our country into a full-blown recession.