In the wake of the subprime lending debacle mortgage lenders and borrowers will operate under a new set of rules. After January 10, 2014, lenders will be required to verify that you can afford to repay a loan prior to cutting a check. It sounds like common sense and in decades past, banks and other financial institutions followed guidelines very similar to the new rules in determining whether a borrower was a good credit risk. At some point over the past 30 years, profits trumped common sense requiring new rules to protect both consumers and lenders.
The Dodd-Frank Wall Street Reform and Consumer Protection Act not only establishes rules for determining a borrower's ability to pay, it also creates the Qualified Mortgage (QM), a new category of loan with more stable features. These rules will protect consumers and level the playing field for all lending institutions.
Redefining Ability to Pay
The new Ability-to-Repay rule requires lenders to gather and verify personal financial information to determine if a you the ability to repay the loan. This information will come from your application, pay stubs, tax returns, W-2 and other official financial documents.
Lenders will collect, verify and analyze the following information:
- Income - Income from employment and investments will be collected and considered as part of the qualifying process.
- Asset statement - Lenders will look at what you own versus what you owe. They want to know if you have property that can help pay your bills if you lose your income. Are your assets liquid and easy to get to?
- Current and past employment - How stable is your employment? Are there any gaps in employment? If so, why?
- Credit history - This will verify information you've given on your application and will also show whether you've defaulted on loans in the past or have been habitually late in paying your bills.
- Total monthly payments for all mortgage loans under consideration at the same time
- Total monthly payments for mortgage related expenses like property taxes
- Total other debts and expenses - A lender will look at no only whether you have the ability to repay the loan being considered, but whether you can pay that loan along with your other debt and expenses.
- Debt to income ratio - This is a comparison of how much you owe to how much you earn.
When determining your ability to pay the lender will generally calculate your monthly payment using the highest interest rate you may be required to pay. So, low initial interest rates can no longer be used to make the mortgage look affordable.
What is a Qualified Mortgage?
The new mortgage rules also define a new mortgage category called the Qualified Mortgage. A QM may not have certain features that put borrowers at risk of default.
A loan is not considered a QM if it has any of the following:
- Loan repayment terms lasting longer than 30 years
- Balloon payments - these are payments due at the end of the term of the loan that are substantially larger than the normal payment
- Negative amortization - this occurs when the loan balance increases despite regular monthly payments having been made
- A period of the loan during which the borrower pays interest only and does not pay down the principal of the note
A QM will also generally have a debt ratio requirement stipulating a borrower's monthly debt payments may not be greater than 43% of monthly pre-tax income. Any fees or points may not be excessive and the borrower is limited in the number of discount points that can be purchased to reduce the interest rate.
Exceptions to the Rules
Balloon Payments
In very limited situations, a balloon payment will be allowed as part of a Qualified Mortgage when issued by a small lender in a rural or underserved area.
Ability to Repay
The factors used in determining your ability to repay are not required to be applied as part of the analysis for some loans, like reverse mortgages, home equity lines, timeshare plans and some temporary loans. There is also an exception when a lender is financing a borrower out of a high-risk mortgage and replacing it with a more stable loan.
