New Consumer Financial Protection Bureau (CFPB) regulations regarding Ability-to-Repay (ATR) and Qualified Mortgages are rolling out Friday, January 10, 2014.
Though the intentions behind the rules are good, I think they could have the unintended consequence of making mortgages more expensive and difficult to get for otherwise qualified mortgage borrowers. And if mortgages are harder to get, it could have a negative impact on a real estate market still struggling to recover from the housing bust and 2008 financial crisis.
The most notable new regulation is the Ability-to-Repay rule, or ATR, which is intended to prevent lenders from making loans borrowers can’t afford to pay back. According to the new rules, lenders will have to “make a reasonable, good faith determination . . . that the consumer has a reasonable ability to repay the loan”. This sounds pretty good so far, right? The problem is that different people have different definitions of what is “reasonable” and a “good faith determination”. If a lender goofs up and a loan goes sour, it could open them up to tens of thousands of dollars in legal damages. Check out the following from the CFPB Ability to Repay lender compliance guide:
However, if consumers have trouble repaying a loan you [the lender] originate, they could claim that you failed to make a reasonable, good faith determination of their ATR before you made the loan. If the consumers prove this claim in court, you could be liable for, among other things, up to three years of finance charges and fees the consumers paid as well as the consumers’ legal fees.
That could add up to a significant chunk of change, which could make lenders very nervous and reluctant to lend. Even if the consumer failed to prove negligence, it still would cost the lender a lot of money to defend themselves.
The Ability to Repay “Safe Harbor”
To address this issue, the CFPB wrote into the rules a “safe harbor” provision. As long as the loan has certain characteristics, it’s called a Qualified Mortgage (QM) and comes with a presumption of compliance with the ATR rules. This means that if a borrower sues the lender, the judge will presume the lender innocent of violations of the ATR rules as long as the loan can be shown to be a QM. From the CPPB lender compliance guide:
Under a safe harbor, if a court finds that a mortgage you [the lender] originated was a QM, then that finding conclusively establishes that you complied with the ATR requirements when you originated the mortgage. For example,a consumer could claim that in originating the mortgage you did not make a reasonable and good faith determination of repayment ability and that you therefore violated the ATR rule. If a court finds that the loan met the QM requirements and was not higher priced, the consumer would lose this claim which greatly reduces the risk of legal liability for lenders.
One exception is if the QM is considered “higher priced”, which means the APR exceeds certain thresholds. Even with a “higher priced” QM, the lender still has significant protections, just not as many as with a non “higher priced” QM.
Because the ATR rules are pretty subjective and there’s a lot of liability associated with a non QM loan, I think there’s a strong likelihood that many lenders simply won’t write loans that aren’t clearly QMs. This could limit financing options for a lot of mortgage borrowers.
Understand that the CFPB has no problem with lenders doing non Qualified Mortgages, they just need to follow prudent underwriting standards per the ATR rules. If a borrower later defaults and sues the lender, a judge could decide that what the lender considered “prudent” really wasn’t and award some big damages. Many lenders simply may not want to take this risk.
So What is a Qualified Mortgage (QM)?
So what the heck is a Qualified Mortgage? The following are some of the required characteristics:
- Maximum debt-to-income (DTI) ratio of 43%. Note that the old conventional lending guidelines allowed for a 45% DTI, sometimes 50% with extenuating circumstances.
- No negative amortization.
- No interest-only.
- No loan terms longer than 30 years.
The DTI limitations are not a disaster in my opinion, but there are plenty of borrowers out there who probably will no longer qualify as a result of them. I’ve done plenty of mortgages with DTIs greater than 43% over the years, but under the new rules, they wouldn’t be considered QMs.
Not only is the maximum DTI being lowered from what was previously allowed under standard Fannie Mae guidelines, but the new rules require lenders to be more strict in how it’s calculated for adjustable-rate mortgages. A lot of people that qualified before may not any longer.
As rates rise in the coming months and years, payments for home buyers will as well, which could mean more people will have trouble qualifying under the new DTI rules. If enough people can’t get mortgages, home values will have to fall to compensate.
Qualified Mortgage Closing Cost Limitations
The most problematic part of the new rules, in my opinion, is the regulation of closing costs. For a loan to be considered a QM, it must meet the following closing cost limitations:
- Maximum 3% of the loan amount for loans greater than or equal to $100,000.
- Maximum $3,000 for loans $60,000 or more but less than $100,000.
- Maximum 5% of the loan amount for loans greater than or equal to $20,000 but less than $60,000.
- Maximum $1,000 for loan amounts greater than or equal to $12,500 but less than $20,000.
- Maximum 8% of the loan amount for loans smaller than $12,500.
Meeting these limits shouldn’t be a problem for large loans, but it likely will be for smaller loan amounts. It’s very difficult for lenders to absorb hard costs and LLPAs into the rate on a small loan amount, so these costs often are charged as fees on the loan. The problem is that all lender fees and LLPAs have to be included in the points and fees limits above.
For example, if a borrower has a condo worth $100,000 and is borrowing $80,000, or 80% LTV, the Fannie Mae LLPA matrix (for loans purchased by Fannie on or after April 1, 2014) has the following price adjustments for a 710 credit score:
- 1.75% of the loan amount for credit score and LTV.
- 0.75% of the loan amount for condo.
Just for these LLPAs we’re already at $2,000 in fees. If this borrower happened to have low credit scores or wanted cash out, even more LLPAs would kick in. It could be impossible to make his loan a QM based on the pricing adjustments alone.
Many lenders also charge lender fees, processing, underwriting, and document prep fees to cover their overhead – all of which have to be included in the points and fees limits. These fees are particularly important for small loan amounts that generate very little interest – and profit – for the lender. Lenders have to make money somewhere, or it simply doesn’t make sense to do the loan.
Lenders often can absorb costs into a slightly higher rate, but there are limitations on APR under the rules as well. If the APR exceeds a certain threshold, the loan falls into the “higher priced” QM category (assuming it meets all other QM requirements) and there is an increased risk of legal liability.
The limitations on closing costs are effectively price controls which I think could make it unprofitable for lenders to do many loans under $100,000. When I started at Lenox Financial, our minimum loan amount was $40,000, but new regulations later made loans that small unprofitable, so the minimum loan amount was raised to $60,000. As a result of these new rules, I wouldn’t be surprised to see lenders raise their minimum loan amount to $80,000 or $100,000, which will make it tough for borrowers in areas with low home prices to get loans.
Are Real Estate Investors Screwed?
Fannie Mae isn’t particularly fond of investment property financing, so it heaps some hefty LLPAs for non owner-occupied and multiunit on top of any other pricing adjustments. These adjustments could make it virtually impossible for all but the largest investment property loans to qualify as QMs. According to the CFPB ATR lender guide, it appears investment property deals may fall under the ATR rules:
The Bureau’s ATR/QM rule applies to almost all closed end consumer credit transactions secured by a dwelling including any real property attached to the dwelling. This means loans made to consumers and secured by residential structures that contain one to four units, including condominiums and coops. Unlike some other mortgage rules, the ATR/QM rule is not limited to first liens or to loans on primary residences (emphasis added).
If this is the case, it could have an significant adverse impact on investment property financing.
The Impact of These New Rules
Some of stuff the CFPB is doing is positive, but I think the good intentions of the CFPB may also come with unintended consequences that could make mortgages more expensive and harder to get for borrowers. The following are a few things that come to mind:
- Reduced competition. Large lenders have the resources to pay for big legal and compliance departments to comply with government regulations. Small lenders and new startup lenders do not, so too much regulation can limit competition, which often results in higher prices for consumers. Now don’t get me wrong, I’m not against regulation, but I think government needs to do it exceedingly carefully to avoid limiting healthy competition in the marketplace.
- Higher costs for lenders mean higher costs for borrowers. Lenders will have to pay the lawyers and compliance professionals to decipher the myriad new rules and implement them. Software will also have to be changed to do the updated calculations and generate the new disclosures. This costs money too, and these costs have to passed on to the consumer.
- Smaller loan amounts may be tougher to get. Small loans make very little money anyway, so if lenders can’t charge enough fees outside the loan to make doing them worthwhile, they won’t do them at all. Between their hard costs and the pricing adjustments that have to be included in the points and fees limits, it just may not be possible to do small QMs. Even if lenders can absorb some of these costs into a higher rate, the loan may end up a “higher priced” Qualified Mortgage and open the lender up to more legal risk. As a result of these limitations and risks, borrowers in areas with lower home values may have more difficulty getting financing.
- More borrowers will not qualify. Between the stricter DTI rules and the fact that many lenders may shy away from doing non QM loans, many borrowers who previously qualified with no problem may have trouble finding a mortgage.
- Lower home values? If enough people find it tougher to get mortgages, it could have an adverse impact on home values. The only reason the housing market is even limping along this much is because lower rates have stimulated mortgage borrowing and the HARP and HAMP programs have somewhat mitigated foreclosures.
- Adverse impact on investment property financing? Because of the risk-based adjustments for investment property, many investment property deals may not qualify as QMs. If lenders see an unreasonable amount of risk in writing non QM business, they simply won’t do it, which could hurt real estate investors.
How all this shakes out remains to be seen, but there’s enough here to make me think it will serve as a significant headwind to the mortgage and real estate markets – along with rising rates over the coming months. We’ll see how all this works out.