Remember the days when lenders would hand out loans based on the borrowers' promises about their income or in anticipation of the house's rises in value? They're gone. And not just because the lenders wised up, but because the Federal Reserve adopted new Truth in Lending rules in 2008, and amended those rules in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
The rules were meant to foster more responsible mortgage lending and protect consumers from predatory mortgages. The catch for consumers is that they now have to demonstrate greater responsibility when borrowing for a home and come to the table with documented evidence that they can truly handle the costs. In short, home buyers have to submit more paperwork and deal with more uncertainty about whether the loan will be approved.
A bit of history: The Home Ownership and Equity Protection Act (HOEPA) was enacted in 1994 as an amendment to the Truth in Lending Act (TILA). However, it mostly dealt with second mortgages. In 2008, the feds released rules covering first mortgages and, especially, subprime loans. Most of the new rules applied only to a new subset of mortgages called “higher priced mortgage loans” -- mortgages that have higher interest rates due to a borrower's poor credit, low down payment, or jumbo loan amount. Among other things, the regulation that implemented HOEPA prohibited a creditor from making a higher priced mortgage loan without regard to the consumer’s ability to repay the loan. In 2010, the Dodd-Frank Act set out similar protections for most closed-end loans and the Consumer Financial Protection Bureau adopted rules implementing the Dodd-Frank provisions.
Here are a few of the key regulatory provisions and how they impact consumers.
Strict Screening of Borrowers' Ability to Repay
Under federal mortgage rules, a lender must look at your financial information and determine if you actually have the ability to repay the loan before extending you the loan.
Ability-to-pay requirement for closed-end mortgage loans. The Dodd-Frank Act established an ability-to-repay rule that applies to most closed-end mortgage loans (such as loans taken out to purchase a home or refinance an existing mortgage) on or after January 10, 2014. (HELOCs, timeshare plans, reverse mortgages, and temporary loans are excluded from the rule.)
The rule requires that lenders make a reasonable, good-faith determination that prospective borrowers have the ability to repay their mortgage by examining the loan payment in relation to the consumer’s ongoing expenses related to the loan (such as property taxes) and other debt obligations. This forces lenders to more closely scrutinize a borrower's debt-to-income ratio, looking for less debt, more income and savings, larger down payments, and other liquid assets the borrower can fall back on, if necessary. It means that consumers will have to take the time to save large down payments, pay off a healthy share of any existing debt, and maintain a pristine credit report for longer than ever before buying a home.
Under the Dodd-Frank Act, a lender is presumed to have met the ability-to-repay requirement if it makes a Qualified Mortgage, which is a mortgage that does not have certain risky features such as negative amortization or interest-only payments. (In addition, a loan must meet certain underwriting criteria to be a Qualified Mortgage. Points and fees are also limited.)
Ability-to-pay requirement for open-end mortgage loans (HELOCs). The Dodd-Frank Act's ability-to-repay requirement does not apply to HELOCs. However, there is a similar ability-to-pay requirement under HOEPA, if the loan is a high-cost mortgage loan. (There are three tests to determine if a transaction is a high-cost mortgage, which are based on: 1. the APR, 2. the amount of points and fees paid in connection with the transaction, and 3. the prepayment penalties charged under the agreement.)
Under HOEPA’s ability-to-repay rule, a lender considering extending a high-cost mortgage to a consumer must consider the consumer’s current and reasonably expected income or assets, as well as the consumer’s other obligations (including property taxes, insurance premiums, and HOA fees, among other things).
Demand for Solid Documentation of Income and Assets
Lenders must now verify the income and assets of borrowers taking out mortgages. This provision has pretty much put so-called "no-doc" loans -- loans granted without documenting qualifying financial information -- onto the dust heap of history, even for lower-cost loans. (They were disparagingly referred to as "liar loans.")
Consumers can no longer just pencil in an arbitrary income amount, but must solidly document income, assets, and their source (by providing W-2s, tax returns, paystubs, bank records, or other documentation), as well as the viability of the numbers and the source. That ideally means longevity on the job and more time holding assets.
This requirement especially squeezes home-based business owners, self-employed people, contract workers, and others who don't get a regular pay stub. Lenders already ask many of these borrowers for a certified public accountant's or other tax professional's certified profit and loss statement to reveal income viability. A tax return is often no longer sufficient proof.
Restrictions on Prepayment Penalties
Lenders are now limited in their ability to charge prepayment penalties. Such fees were often slapped on borrowers trying to get out of low initial cost and subprime loans they'd taken out before and during the housing boom. Borrowers who had held their mortgage for only a few years, and wanted to refinance or sell the home, had to pay exorbitant penalties.
Homeowners were often compelled to refinance, because the same loans that came with prepayment penalties were also negatively amortizing or they were facing a big balloon payment. However, with penalties so high -- equal to interest payments for six months -- they locked borrowers into an unaffordable loan, even when a more affordable loan was available.
When prepayment penalties are allowed. Under the new rules, prepayment penalties are only allowed if:
- the APR cannot increase after you take out the loan (for example, fixed rate loans)
- the loan is a Qualified Mortgage, and
- the loan is not a higher-priced mortgage loan. (A higher-priced mortgage loan is a mortgage with an annual percentage rate higher than a benchmark rate called the Average Prime Offer Rate, which is an annual percentage rate that is based on average interest rates, fees, and other terms on mortgages offered to highly qualified borrowers.)
Further limitations on prepayment penalties. In addition, if a prerepayment penalty is allowed, it is subject to the following restrictions:
- a prepayment penalty is only allowed during the first three years after the loan is consummated
- for the first two years after the loan is consummated, the penalty cannot be greater than 2% of the amount of the outstanding loan balance
- for the third year, the penalty is capped at 1% of the outstanding loan balance, and
- if a lender offers a loan that includes a prepayment penalty, the lender must also offer an alternative loan that does not include a prepayment penalty. (In doing this, the lender must have a good faith belief that the consumer likely qualifies for the alternative loan.)
Ban on Prepayment Penalties for High-Cost Mortgages
As required by the Dodd-Frank Act, HOEPA prohibits prepayment penalties for high-cost mortgages.
Where to Find More Information
Additional highlights of the final rules that amend the home mortgage provisions of Regulation Z (Truth in Lending) can be found on the Consumer Financial Protection Bureau’s website.
For more information on researching, choosing, and qualifying for an affordable mortgage, see Nolo's Essential Guide to Buying Your First Home, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo).