The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) amended the Truth in Lending Act (TILA) to provide for an expanded ability-to-repay requirement for the mortgage lending industry. The Consumer Financial Protection Bureau (CFPB) was tasked with developing the necessary rulemaking to amend Regulation Z. On January 10, 2013, the CFPB issued the highly anticipated final ability-to-repay rule requiring lenders to verify a consumer’s ability to repay a mortgage loan and defining a “qualified mortgage” (Final Rule). The Final Rule becomes effective on January 10, 2014.

The Final Rule is predicted to create wide-ranging consequences for the residential mortgage market including the potential contraction of available credit, likely restriction of the mainstream residential mortgage markets to qualified mortgages and the salability on the secondary market of loans considered “higher-priced covered transactions” under the Final Rule. From a litigation perspective, it is not inconceivable that a wide variety of potential litigation matters may arise out of these broader impacts on the availability of credit and secondary mortgage markets. However, with respect to front-line consumer litigation issues, the Final Rule will certainly create new fodder for consumer litigation.

Civil Liability Issues

Violations of the ability-to-repay requirements of the Final Rule will subject the creditors and assignees to, among other consequences, civil liability under TILA and also provide the borrower with a defense to foreclosure. The borrower may recover, in addition to actual damages, statutory damages in an individual or class action, plus costs and attorneys’ fees. Further, the Dodd-Frank amendments to TILA also provide for special statutory damages for the violation of the ability-to-repay requirement equal to the total of all finance charges and fees paid by the borrower, unless the failure to comply with the requirements was immaterial. Finally, the statute of limitations for civil actions arising from ability-to-repay violations has been extended to three years and, notably, the assertion of an ability-to-repay violation as a defense to foreclosure is not subject to any statute of limitations. As a result, the definitions and exemptions established by the Final Rule and summarized below will likely have a substantial influence on both the availability and cost of residential mortgage credit.

Ability-to-Repay Requirements

The ability-to-repay requirements apply to “covered transactions,” which are defined as consumer credit transactions that are secured by a dwelling, including any real property attached to a dwelling. “Dwelling” is further defined as a residential structure consisting of one to four units. The following are exempt from the ability-to-pay requirements: home equity lines of credit or timeshares, reverse mortgages, temporary or bridge loans with terms of 12 months or less and the construction phase of a 12-month or less construction-to-permanent loan. The requirements also do not apply to an extension of credit made primarily for business, commercial or agricultural purposes, even if secured by a dwelling.

The general ability-to-repay requirement provides: “A creditor shall not make a loan that is a covered transaction unless the creditor makes a reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” There has been an ability-to-repay requirement in place since October 2009, when the Federal Reserve Board adopted a rule under TILA amending Regulation Z to prohibit creditors from making “higher-priced mortgage loans” without assessing a consumer’s ability to repay the loans. The Final Rule now expands and extends the ability-to-repay requirement to essentially all closed-end consumer credit transactions secured by a dwelling. However, the Final Rule’s specific ability-to-repay requirements, while similar, are not identical to those currently in effect for “higher-priced mortgage loans” under Regulation Z.

The Final Rule does not establish a specific underwriting model. The creditor must, at a minimum, consider the following eight underwriting factors pertaining to the individual consumer in assessing their ability-to-repay the loan:

• the current or reasonably expected income or assets of the consumer securing the loan (other than the value of the dwelling, including any real property attached to the dwelling);
• the current employment status of the consumer if the creditor is relying on income from that employment to determine the ability to repay the loan;
• the consumer’s monthly payment on the covered transaction, calculated using the greater of a fully indexed rate or any introductory rate and using monthly, fully amortizing payments that are substantially equal;
• the consumer’s monthly payment on any simultaneously made loan that the creditor knows, or has reason to know, will be made;
• the consumer’s monthly payment for mortgage-related obligations such as property taxes, insurance premiums, fees and special assessments imposed by a homeowners’ or similar association;
• the consumer’s current debt obligations including alimony and child support;
• the consumer’s monthly debt-to-income (DTI) ratio, which means the ratio of total monthly debt obligations to total monthly income or residual income; and
• the consumer’s credit history.

The Final Rule requires the creditor to verify the information it relies upon in determining the consumer’s ability to repay using reasonably reliable third-party records. The creditor need not verify income or assets that it does not rely upon to evaluate the consumer’s repayment ability. In verifying income or assets, the credit may rely upon tax return transcripts from the IRS, copies of tax returns, Form W-2s, payroll statements, financial institution records, government benefit or entitlement records, check cashing service receipts or funds transfer service receipts. Employment may be verified orally provided the creditor keeps a record of the verification.

Under the Final Rule, the creditor must determine the consumer’s long-term ability to repay both the principal and interest and not just the ability to repay the loan during an introductory or “teaser” period. In essence, creditors can no longer offer no-doc, low-doc “Alt-A” loans.

Refinancing of “Riskier” Mortgages May be Exempt

There is an exemption for lenders assisting consumers in refinancing riskier loans (such as adjustable-rate mortgages, interest-only loans, or negative-amortization loans) to standard and more stable loans. The following considerations may create an exemption to the ability-to-repay rule:

• whether the standard mortgage will likely prevent a default by the consumer on the non-standard mortgage once refinanced;
• the creditor for the standard mortgage is also the holder or servicer of the non-standard mortgage;
• the monthly loan payment on the standard mortgage will be materially lower than the monthly payment on the non-standard mortgage;
• the creditor obtains the consumer’s written application within two months after the refinancing of the non-standard mortgage;
• the consumer has not had more than one payment more than 30 days late during the 12 months prior to the creditor’s receipt of the written application;
• the consumer has not made any payments more than 30 days late during the six months prior to the creditor’s receipt of the written application; and
• if the non-standard mortgage was originated after the effective date of the Final Rule (January 10, 2014), it was made in accordance with the Final Rule’s ability-to-repay and qualified mortgage requirements.

Definition of “Qualified Mortgage”

Creditors are presumed to have complied with the ability-to-repay requirements if they issue “Qualified Mortgages.” Qualified Mortgages must meet certain requirements that prohibit or limit certain riskier aspects of mortgage loans.

• No excess upfront points and fees. The loan must not have total points and fees in excess of 3 percent of the total loan amount for a loan equal to or greater than $100,000, less up to two bona fide discount points if the interest rate, without any discount, does not exceed the average prime rate offer by more than one percentage point. The components of this cap are likely to raise significant issues. The Final Rule includes both direct and indirect loan originator compensation as well as closing charges paid to affiliated settlement providers such as lender-owned title companies. This cap is likely to put significant pressure on mortgage brokers and wholesale lending business models and on the use of affiliates.
• The loan term does not exceed 30 years.
• Cap on how much income can go toward debt repayments. The consumer’s DTI should not exceed 43 percent. The Final Rule contains an exemption to the DTI threshold for a transitional period during which a covered transaction with a DTI exceeding 43 percent may be considered a Qualified Mortgage if the other criteria for a Qualified Mortgage are satisfied and if the loan meets government affordability or other standards, such as being eligible to be purchased, guaranteed or insured by Fannie Mae or Freddie Mac (while they operate under Federal conservatorship or receivership), the U.S. Department of Housing and Urban Development, Department of Veterans Affairs or the Department of Agriculture or Rural Housing Service. The exemption will not apply to loans originated after January 10, 2021. Note that jumbo loans, by definition, could not qualify under this alternative and, thus will have to be made at 43 percent DTI just to pass the Qualified Mortgage underwriting test.
• No loans with balloon payments. Generally, a loan with a balloon payment will not be considered a Qualified Mortgage. However, the Final Rule contains an exemption for loans with balloon payments if they are originated and held by small creditors operating in predominantly rural or underserved areas, have a term of at least five years, a fixed-interest rate and meet certain basic underwriting standards.
• No interest only or graduated payment loans that allow the consumer to defer repayment of the principal.
• No negative-amortization loans that result in an increase in the principal balance.
• Follow established general underwriting criteria for Qualified Mortgages. Monthly payments should be calculated based on the highest payment that will apply in the first five years of the loan and establish periodic payments of principal and interest that will repay either the loan amount over the loan term or the outstanding principal balance over the remaining loan term as of the date the interest rate adjusts to the maximum.
• The creditor must consider and verify at or before consummation of the loan the consumer’s current or reasonably expected income or assets and the consumer’s current debt obligations including alimony and child support. The value of the dwelling and any real property attached to the dwelling securing the loan may not be considered as assets for this purpose.

The “Safe Harbor” and “Rebuttal Presumption” Distinction

Dodd-Frank amended TILA to provide that with respect to a residential mortgage loan, a creditor or any assignee, is entitled to presume the loan has met the ability-to-repay requirement if the loan is a Qualified Mortgage. It is unclear, however, whether Congress intended this provision to constitute a “safe harbor” or a “rebuttable presumption” of compliance with the ability-to-repay requirement -- a distinction with substantial significance in consumer litigation. The Final Rule adopts both a “safe harbor” and a “rebuttable presumption” approach depending on whether the loan constitutes a “higher-priced covered transaction.”  

The “safe harbor” applies to covered transactions that meet the definition of Qualified Mortgage but do not constitute “higher-priced covered transactions.” A “higher-priced covered transaction” is defined as “a covered transaction with an annual percentage rate that exceeds the average prime offer rate for a comparable transaction as of the date the interest rate is set by 1.5 or more percentage points for a first-lien covered transaction, or by 3.5 or more percentage points for a subordinate-lien covered transaction.” Any covered transaction that constitutes a Qualified Mortgage but is not a “higher-priced covered transaction” will be subject to the safe harbor. This safe harbor means that the creditor or any assignee is conclusively presumed to have made the required ability-to-repay determination. The consumer, however, may still raise the threshold issue in any litigation of whether the loan constitutes a Qualified Mortgage in the first instance.

On the other hand, for any covered transaction that meets the definition of Qualified Mortgage but is a “higher-priced covered transaction,” the creditor or assignee is only presumed to have complied with the ability-to-repay requirements and that presumption may be rebutted. The Final Rule defines certain limited circumstances under which the presumption may be rebutted. To rebut the presumption, the consumer must prove that the creditor did not make a good faith determination of the consumer’s ability-to-repay at the time of the loan origination. The consumer must prove that the consumer’s income, debt obligations, alimony, child support and monthly payments of which the creditor was aware, left insufficient residual income or assets to meet living expenses. Again, the value of the dwelling and any attached real estate securing the loan must be excluded from this calculation. The Final Rule indicates, however, that the longer the consumer has made timely payments, the less likely the consumer will be able to rebut the presumption of compliance with the ability-to-repay rule.

Concurrent Proposal

The CFPB also released a concurrent proposal seeking comment on whether further modifications should be made to the Final Rule to address potential adverse consequences on narrow segments of the lending industry. Specifically, the concurrent proposal seeks comment on whether designated non-profit lenders, homeownership stabilization programs and certain Federal agency and Government-Sponsored Enterprise refinancing programs should be exempt from the ability-to-repay requirements because they are already subject to their own specific underwriting criteria. The concurrent proposal is also seeking comment on whether a new category of qualified mortgages should be created for loans without balloon-payment features that are originated and held by small creditors. The concurrent proposal is also seeking comment on whether to increase the threshold separating safe harbor and rebuttable presumption qualified mortgages for both rural balloon-payment mortgages and the new small portfolio qualified mortgages due to the often higher costs of funds experienced by small creditors.