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.
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 underlying law that the feds are tightening up is called the Home Ownership and Equity Protection Act (HOEPA), which was enacted in 1994. However, it mostly dealt with second mortgages, whereas the 2008 rules cover first mortgages and, especially, subprime loans.
Most of the new rules apply only to higher priced mortgages -- mortgages that have higher interest rates due to a borrower's poor credit, low down payment, or jumbo loan amount. Here are the key regulatory provisions and how they impact consumers.
Strict Screening of Borrowers' Ability to Repay
Lenders can no longer make home loans without looking at whether the borrower is likely to be able to repay them using income and assets other than the home's value. If the loan payments will vary month by month, then the lender will have to assess repayment ability based on the highest scheduled payment in the first seven years of the loan.
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.
Demand for Solid Documentation of Income and Assets
Lenders must now verify the income and assets of borrowers taking out higher priced 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, as well as the viability of the numbers and the source. That ideally means longevity on the job and more time holding assets.
This provision 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.
Partial Ban on Prepayment Penalties
This one's mostly good for consumers: Lenders are restricted in whether they can add prepayment penalties to a higher priced loan contract. 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.
The new rules ban prepayment penalties on any loans where the monthly payment can change in the first four years. On other loans, the new rules prevent a prepayment penalty period from lasting for more than two years. That is, after the two-year period, the borrower is free to refinance or sell the home without penalty.
The one downside, however, is that, without the ability to all but lock consumers into certain loans, lenders are offering a narrower variety of loans and charging higher interest for any loans that are remotely unusual, forcing many consumers out of the market and others to spend more time shopping around.
Escrow Accounts for Principal and Interest
Lenders must now establish escrow accounts for property taxes and homeowners insurance' on all higher-priced first-mortgage loans. That means the full mortgage payment will include not only principal and interest, but also taxes and insurance (PITI).
Up to now, most lenders required escrow accounts only when the buyer put down less than a 15-20% down payment. (The new rules probably represent a better approach to paying these housing costs than the gamble many homeowners were taking!) Homeowners will have these costs spread out over 12 monthly payments rather than struggling to pay large insurance and tax bills in one lump sum, which should make the monthly cost of home ownership more self-evident before the loan closes.
Where to Find More Information
Additional highlights of the final Federal Reserve rules that amend the home mortgage provisions of Regulation Z (Truth in Lending) can be found on the Federal Reserve 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).