On January 10, 2013, the Consumer Financial Protection Bureau (CFPB) issued the final rules amending Regulation Z in order to implement the ability to repay requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). These final rules (the Final Rules) build on the proposed rules first issued by the Board of Governors of the Federal Reserve System (the Board) on April 18, 2011, although there are substantive differences between the two versions. For example, while the proposed rules contemplated either a safe harbor or a rebuttable presumption of compliance with ability to repay requirements if a lender writes a qualified mortgage (QM), the Final Rules incorporate both concepts. Additionally, the CFPB has also proposed revisions to the Final Rules to extend QM protections to community banks and credit unions. The Final Rules will not go into effect until January 10, 2014, in order to give mortgage lenders time to adjust to these sweeping changes.
General Ability to Repay Standard
Through the addition of a new section (12 C.F.R. 1026.43), the Final Rules build on the ability to repay requirements that were already built into so-called HOEPA loans. However, while HOEPA loans traditionally excluded many types of mortgages (including purchase money loans), the Final Rules apply to all “covered transactions”, which are consumer credit transactions secured by a dwelling. The only kinds of mortgage loans excluded from this definition are home equity lines of credit, mortgages secured by interests in timeshare plans, reverse mortgages, temporary or “bridge” loans of 12 months or less, and the 12-month or less construction phase of construction-to-permanent loans. In this update, unless otherwise indicated, a reference to a loan refers to a covered transaction.
Generally, unless a covered transaction is subject to one of the ability to repay exceptions described below, the lender must consider a consumer’s ability to repay a mortgage loan before making such loan, and in doing so must consider the following:
- The consumer’s current or reasonably-expected income or assets, excluding the dwelling in question;
- The consumer’s current employment status, if the consumer relies on that income;
- The consumer’s monthly payment on the covered transaction;
- The consumer’s monthly payment on any simultaneous loans that the lender knows or has reason to know will be made;
- The consumer’s monthly payment for mortgage-related obligations, including property taxes, premiums, and similar charges;
- The consumer’s current debt obligations, alimony, and child support;
- The consumer’s monthly debt-to-income ratio or residual income; and
- The consumer’s credit history.
These standards appear to be similar to those promulgated in the proposed rules. The Final Rules require the lender to verify the consumer’s income or assets using reasonably-reliable third party records, such as a tax-return transcript issued by the Internal Revenue Service. Additionally, when calculating the consumer’s monthly payment on the proposed covered transaction, the lender must used either the “fully indexed rate” or the introductory rate, whichever is greater, and use monthly, fully amortizing payments that are substantially equal. For these purposes, “fully indexed rate” means the interest rate calculated using the index or formula that will apply after a recast of the loan, as determined at the time of consummation, and the maximum margin that can apply at any time during the loan.
The Final Rules provide separate standards for determining the consumer’s monthly payment for balloon, interest-only, and negative-amortization loans. For a balloon loan, the lender must consider the maximum scheduled payment during the first 5 years of the loan if the loan is not a “higher-priced covered transaction”, or the maximum payment in the loan schedule if the loan is a higher-priced covered transaction. For these purposes, “higher-priced covered transaction” is very similar to the current definition of a higher-priced mortgage loan, and means a covered transaction with an APR that exceeds the average prime offer rate (a term defined in the current 12 C.F.R. 1026.35) for a comparable transaction as of the date the interest rate is set by 1.5 or more percentage points for a first-lien loan, or by 3.5 or more percentage points for a subordinate-lien loan. Please note here that the proposed rules suggested that current section 12 C.F.R. 1026.35 would be unnecessary because the provisions applicable to higher-priced mortgage loans would be covered elsewhere (such as the Final Rules and the CFPB’s escrow rule) and proposed deleting it. However, the Final Rules keep that section in place.
Ability to Repay Alternatives – QM
The penalties involved for not properly considering a consumer’s ability to repay the loan can be harsh. Under the Truth in Lending Act (TILA), if a lender or the assignee of a lender brings a foreclosure action against a borrower, the borrower can assert a recoupment or set-off defense to the foreclosure action in an amount up to three times the applicable finance charge of the loan, plus costs and attorneys fees. After a period of time, this limit drops to the finance charge plus costs, but there is no ultimate time limit to the borrower’s ability to raise this defense under TILA.
The CFPB appears to recognize the need to provide lenders with some assurances in the face of such a potentially costly defense to foreclosure. In its conference on the Final Rules held in Baltimore, Maryland on January 10, 2013, Richard Cordray (director of the CFPB) stated that the goals of the Finals Rules are two-fold: Protect consumers from loans that are designed to fail, and unfreeze the credit markets by offering lenders some form of assurance in the face of the potentially-costly TILA-mandated foreclosure defenses, in order to convince them to begin offering mortgage products again.
To that end, the Final Rules offer lenders several options for exemption from the baseline ability to repay standards described above. The most important of these is probably the QM. Under the proposed rules, the Fed envisioned the QM offering lenders either a “safe harbor” from the ability to repay requirement, or a “rebuttable presumption” of compliance with the ability to repay requirement that a consumer could challenge in court. By contrast, the Final Rules incorporate both concepts. A covered transaction that both meets the criteria of a QM (as described below) and is not a higher-priced covered transaction offers lenders a safe harbor from the ability to repay requirements. In other words, the lender is deemed to have automatically complied with the ability to repay requirement by offering a “prime” QM. QMs that are higher-priced covered transactions, on the other hand, provide lenders with a “rebuttable presumption” of compliance with the ability to repay requirement. In other words, for such a loan, the lender is presumed to have complied with the ability to repay requirement. However, the consumer can rebut this presumption by demonstrating that the lender did not make a reasonable and good faith determination of the consumer’s repayment ability at the time of consummation, by showing that the consumer’s income, debt obligations, alimony, child support, and monthly payment on both the covered transaction and on simultaneous loans would leave the consumer with insufficient residual income or assets with which to meet living expenses. Presumably, the consumer’s ability to rebut the ability to repay presumption for higher-priced QMs will increase the cost of such loans even further. As the CFPB noted in the Baltimore conference, however, it is very important to note that even a safe harbor for a prime loan does not offer the lender perfect protection from a TILA recoupment defense against foreclosure, since the consumer always has the ability to attempt to demonstrate that the loan in question never met the criteria for a QM in the first place.
Consumer advocacy groups have questioned this two-tier system and suggested that it may encourage lenders to steer minority consumers to subprime loans, despite the greater protection offered for such loans through the rebuttable presumption; these groups have generally called for the rebuttable presumption to apply to all covered transactions. However, the CFPB has indicated that it feels that this two-tier system is the best way to offer some measure of security to both lenders and consumers, that it protects the ability of lenders to offer subprime loans when appropriate, and that other consumer protection laws, such as fair lending laws, would also be in place to protect consumers from steering problems.
Under the Final Rules, a QM (regardless of whether it is a higher-priced covered transaction or not) generally must meet certain loan characteristics. This is different from the standard ability to repay requirement described above, which does not actually place limitations on terms of the loan in question. To be a QM, a loan must meet the following criteria:
- The loan provides for regular periodic payments that are substantially equal (except for the effect of an interest rate change after consummation for an adjustable-rate or step-rate loan) and such payments do not increase the principal balance, allow the consumer to defer payment of principal, and do not result in a balloon payment;
- The loan term does not exceed 30 years;
- The total points and fees payable in connection with the transaction do not exceed 3% of the total loan amount (adjusted for inflation) for loans of $100,000 or more (with adjusted caps for lower loan amounts);
- The lender underwrites the loan, taking into account the monthly payment for mortgage-related obligations, using the maximum interest rate that will apply in the first 5 years of the loan and periodic payments of principal and interest that will repay either the outstanding principal balance over the remaining term of the loan, or the loan amount over the loan term;
- The lender verifies the consumer’s current or reasonably-expected income or assets, current debt obligations, alimony and child support, using methods detailed in the Final Rule; and
- With the loan, the consumer’s ratio of total monthly debt to total monthly income does not exceed 43%; consumer advocacy groups present at the CFPB’s conference in Baltimore expressed concern at this requirement, particularly with respect to low-income consumers.
The definition of “points and fees” for these purposes in the Final Rules appears to be substantially similar to the definition in the proposed rules. It excludes up to two bona fide discount points paid by the consumer, if the interest rate does not exceed certain amounts, and includes, for example, all real-estate related fees (such as title insurance fees and appraisal fees) that are paid to an affiliate of the lender, and all bona fide third-party charges that are retained by an affiliate of the lender or the loan originator. While the CFPB recognizes in the Final Rules that it received many comments from the industry that these inclusions will unduly harm lenders with affiliated service providers, the CFPB has left this provision in the Final Rules anyway. It has indicated in the Final Rules that it believes that Congress took this risk into account when it included affiliate charges into points and fees.
Additionally, the definition of “points and fees” also includes all compensation paid directly or indirectly by a consumer or lender to a loan originator that can be attributed to that transaction at the time the interest rate is set. The Final Rules clarify that this does not include compensation that cannot be attributed to the specific transaction, such as compensation based on long-term performance of loans or a loan originator’s base salary. However, the CFPB is aware of the inherent problems presented by this provision, such as resulting higher prices if consumer payments are not offset against lender-paid loan compensation and the affect on mortgage brokers and their employees. Therefore, the CFPB is issuing a concurrent proposal (the Proposal) that requests comments on whether offsetting should be permitted, and also on the treatment of mortgage brokers in the wholesale market.
Specifically, the Proposal would clarify that because mortgage broker fees are already included in the finance charge, they would not also be counted as compensation paid to a loan originator, as this would result in “double-dipping” and unjustified inflation of the total points and fees. Additionally, the Proposal offers two alternatives for a lender’s origination fees generally. Under the first alternative, if the consumer pays an origination fee and the lender pays its loan officer compensation related to the transaction, these would both count towards the points and fees cap. Under the second alternative, the amount of loan officer compensation included in the points and fees calculation would be reduced by any amount included in the points and fees calculation through the finance charge; so, if a consumer pays an origination fee and the lender pays the loan officer compensation related to the transaction, the lender can reduce the value of that compensation for points and fees calculation purposes by the amount of the origination fee. Comments on the Proposal are due by February 25, 2013.
Finally, the CFPB recognizes that the proposed expansion of the definition of “finance charge” in the CFPB’s integrated TILA/RESPA proposed rules could make it significantly more difficult for lenders to meet the points and fees cap requirement, since the definition of “points and fees” is ultimately tied to the finance charge. However, the CFPB has indicated that it will address this issue when it finalizes the finance charge rule.
Ability to Repay Alternatives – Temporary QM
In recognition of the fact that other government agencies have been tasked with developing their own “QM” definitions that would meet ability to repay requirements, the CFPB has provided for a special expansion of the definition of QM for certain loans. These loans must meet the first three criteria described above. Additionally, the loan must be eligible for purchase or guaranty by Fannie Mae or Freddie Mac (while they are under the conservatorship or receivership of the Federal Housing Finance Agency), eligible for insurance by HUD, eligible for guaranty by the VA, eligible for guaranty by the Department of Agriculture, or eligible for insurance by the Rural Housing Service. These special expansions expire on the earlier of the effective date by a given agency of a rule defining a QM for that agency, and January 10, 2021 for all agencies.
Ability to Repay Alternatives – Non-Standard Refinancing
Under the Final Rules, a lender that refinances a “non-standard” loan into a “standard” loan is exempt from the general ability to repay requirement. For these purposes, a “non-standard” loan is a covered transaction that is either an adjustable-rate mortgage with an introductory fixed-rate period of one year or longer, an interest-only loan, or a negative amortization loan. A “standard” loan, on the other hand, is a covered transaction (i) that provides for regular payments do not increase the principal balance, allow the consumer to defer payment of principal, and do not result in a balloon payment, (ii) meets the points and fees cap described above, (iii) does not have a term of more than 40 years, (iv) has a fixed interest rate for at least the first 5 years of the loan, and (v) the proceeds of which are only used to pay off the outstanding principal balance on the non-standard loan and to pay closing or settlement charges required to be disclosed under RESPA.
In order to take advantage of the ability to repay exemption for such a refinancing, the following conditions must be met:
- The lender for the standard loan is the current holder of the existing non-standard loan or is a servicer acting on such holder’s behalf;
- The monthly payment for the standard loan is materially lower than the payment for the non-standard loan, as calculated under the terms of the Final Rule;
- The lender receives the application for the standard loan no later than 2 months after the non-standard loan has recast;
- The consumer has made no more than one payment that is more than 30 days late on the non-standard loan within the preceding 12 months;
- The consumer has made no payments more than 30 days late during the preceding 6 months;
- The non-standard loan was either a QM or made under the general ability to repay standard for loans consummated after January 10, 2014; and
- The lender has considered whether the standard loan will likely prevent a default by the consumer on the non-standard loan once the loan is recast.
Ability to Repay Alternatives – Balloon QMs
Notwithstanding the general prohibition against balloon terms for QMs, the Final Rule does permit a QM to contain a balloon payment feature, provided that certain conditions are met. With respect to such a loan, (i) the loan cannot have a negative amortization feature, (ii) the loan must have a term of at least 5 years but cannot exceed 30 years, (iii) the loan must meet the general QM points and fees cap, (iv) the lender must generally verify the consumer’s current or reasonably-expected income or assets, current debt obligations, alimony and child support, without having to use the standards set forth in the Final Rule, (v) the lender must determine that the consumer can make all scheduled payments together with all monthly payments for all mortgage-related obligations (excluding the balloon payment) from the consumer’s current or reasonably-expected income or assets, (vi) the lender considers the consumer’s monthly debt-to-income ratio (except that this is not subject to the 43% requirement), (vii) the loan provides for scheduled payments that are substantially equal, as calculated using an amortization period that does not exceed 30 years, and (viii) the loan has a fixed interest rate.
The lender of a balloon QM must meet certain eligibility requirements. Generally speaking, the lender must originate at least 50% of its first-lien mortgage loans in areas that are rural or underserved, must have less than $2 billion in assets, and together with any affiliates, must originate no more than 500 first-lien mortgage loans per year.
Additionally, a balloon QM loses its QM status if it is sold, assigned, or transferred after consummation, except under certain limited circumstances (such as the transfer occurring 3 or more years after consummation of the loan, or the loan being transferred to another lender who meets the eligibility requirement to make balloon QMs).
Ability to Repay Alternatives – Proposed Additions
As described above, in addition to the Final Rules, the CFPB has also offered additional terms for consideration in the Proposal, in recognition of the important roles that housing assistance programs and non-profits can play in the mortgage lending industry. The Proposal would amend the Final Rule to generally exclude from the definition of “covered transaction” (and consequently the ability to repay requirement) loans or extensions of credit made by non-profits, community development institutions, and housing assistance programs.
Additionally, at the urging of credit union and community bank associations (several of which were in attendance at the CFPB’s conference in Baltimore), the CFPB is proposing an addition to the definition of QM that would offer such institutions a safe harbor or rebuttable presumption of compliance with the general ability to repay requirements, depending on the higher-priced status of the loan in question. Such a QM would generally have to meet the QM requirements described above, except for the 43% debt-to-income ratio restriction. The lender would have to consider the consumer’s monthly debt-to-income ratio generally and verify the consumer’s obligations and income. As with balloon QMs, this kind of QM generally could not be transferred after consummation, except under certain circumstances. Finally, the lender would have to have less than $2 billion in assets, and together with any affiliates, must originate no more than 500 first-lien mortgage loans per year. As noted above, comments on the Proposal are due by February 25, 2013.
The Final Rule places certain prepayment penalty restrictions on all covered transactions. Generally, a covered transaction cannot include a prepayment penalty unless:
- The penalty is otherwise permitted by law;
- The APR cannot increase after consummation;
- The loan is otherwise a QM (whether a regular QM, a special temporary QM, or a balloon QM); and
- The loan is not a higher-priced mortgage loan, as defined in current 12 C.F.R. 1026.35(a), which appears to track closely the definition of a “higher-priced covered transaction” used throughout the ability to repay requirements, and which would appear to effectively mean that covered transactions subject to prepayment penalties will have to be “prime” QMs subject to the safe harbor.
If a loan is permitted to have a prepayment penalty, such a penalty cannot apply after the third year following consummation, must not exceed 2% of the outstanding loan balance prepaid during the first two years after consummation, and must not exceed 1% of the outstanding loan balance prepaid during the third year after consummation. Additionally, a lender offering a consumer a loan subject to a prepayment penalty must also offer that consumer a loan without the penalty feature and that also includes certain other features, such as having the same loan terms as the loan with the prepayment penalty, and having either a fixed interest rate or a step interest rate. Finally, the CFPB prohibits a loan being structured as open-end credit to avoid the prepayment penalty requirements.
It is important to note with respect to prepayment penalties that with the revisions to the definition of a “high-cost” mortgage also promulgated by the CFPB on January 10, 2013, if a prepayment penalty extends past 3 years or is ever higher than 2%, the applicable loan will automatically be in violation of the high-cost mortgage loan rules.
The Final Rules require lenders to retain evidence of compliance with Regulation Z for 2 years after the date that action is required to be taken, or 3 years in the case of demonstrating compliance with the ability to repay requirements.