Stricter Mortgage Requirements for Homebuyers

Remember the days when lenders wouldhand out loans based on the borrowers' promises about their income or inanticipation of the house's rises in value? They're gone. And not just becausethe lenders wised up, but because the Federal Reserve adopted new Truth inLending rules in 2008, and amended those rules in 2010 with the Dodd-Frank WallStreet Reform and Consumer Protection Act (Dodd-Frank Act).

The rules were meant to foster moreresponsible mortgage lending and protect consumers from predatory mortgages.The catch for consumers is that they now have to demonstrate greaterresponsibility when borrowing for a home and come to the table with documentedevidence that they can truly handle the costs. In short, home buyers have tosubmit more paperwork and deal with more uncertainty about whether the loanwill be approved.

A bit of history: The Home Ownershipand Equity Protection Act (HOEPA) was enacted in 1994 as an amendment to theTruth in Lending Act (TILA). However, it mostly dealt with second mortgages. In2008, the feds released rules covering first mortgages and, especially,subprime loans. Most of the new rules applied only to a new subset of mortgagescalled “higher priced mortgage loans” mortgages that have higher interestrates due to a borrower's poor credit, low down payment, or jumbo loan amount. Amongother things, the regulation that implemented HOEPA prohibited a creditor frommaking a higher priced mortgage loan without regard to the consumer's abilityto repay the loan. In 2010, the Dodd-Frank Act set out similar protections for most closed-end loans and the Consumer FinancialProtection Bureau adopted rules implementing the Dodd-Frank provisions.

Here are a few of the key regulatory provisionsand how they impact consumers.

Strict Screening of Borrowers' Ability to Repay

Under federal mortgage rules, a lendermust look at your financial information and determine if you actually have theability to repay the loan before extending you the loan.

Ability-to-payrequirement for closed-end mortgage loans. TheDodd-Frank Act established an ability-to-repay rule that applies to mostclosed-end mortgage loans (such as loans taken out to purchase a home orrefinance an existing mortgage) on or after January 10, 2014. (HELOCs, timeshare plans, reverse mortgages, andtemporary loans are excluded from the rule.)

The rule requires that lenders make areasonable, good-faith determination that prospective borrowers have theability to repay their mortgage by examining the loan payment in relation tothe consumer's ongoing expenses related to the loan (such as property taxes)and other debt obligations. This forces lenders to more closely scrutinize aborrower's debt-to-income ratio, looking for less debt, more income andsavings, larger down payments, and other liquid assets the borrower can fallback on, if necessary. It means that consumers will have to take the time tosave large down payments, pay off a healthy share of any existing debt, andmaintain a pristine credit report for longer than ever before buying a home.

Under the Dodd-Frank Act, a lender ispresumed to have met the ability-to-repay requirement if it makes a QualifiedMortgage, which is a mortgage that does not have certain risky features such asnegative amortization or interest-only payments. (In addition, a loan must meetcertain underwriting criteria to be a Qualified Mortgage. Points and fees are alsolimited.)

Ability-to-payrequirement 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 loanis 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 lenderconsidering extending a high-cost mortgage to a consumer must consider the consumer's current and reasonably expected income or assets, aswell as the consumer's other obligations (including property taxes, insurancepremiums, and HOA fees, among other things).

Demand for Solid Documentation of Income and Assets

Lenders must now verify the income andassets of borrowers taking out mortgages. Thisprovision has pretty much put so-called "no-doc" loans loansgranted without documenting qualifying financial information onto the dustheap of history, even for lower-cost loans. (They were disparagingly referredto as "liar loans.")

Consumers can no longer just pencil inan arbitrary income amount, but must solidly document income, assets, and theirsource (by providing W-2s, tax returns, paystubs, bank records, or otherdocumentation), as well as the viability of the numbers and the source. Thatideally means longevity on the job and more time holding assets.

This requirement especially squeezeshome-based business owners, self-employed people, contract workers, and otherswho don't get a regular pay stub. Lenders already ask many of these borrowersfor a certified public accountant's or other tax professional's certifiedprofit and loss statement to reveal income viability. A tax return is often nolonger 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 oflow initial cost and subprime loans they'd taken out before and during thehousing boom. Borrowers who had held their mortgage for only a few years, andwanted to refinance or sell the home, had to pay exorbitant penalties.

Homeowners were often compelled torefinance, because the same loans that came with prepayment penalties were alsonegatively amortizing or they were facing a big balloon payment. However, withpenalties so high equal to interest payments for six months they lockedborrowers into an unaffordable loan, even when a more affordable loan wasavailable.

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 finalrules that amend the home mortgage provisions of Regulation Z (Truth in Lending)can be found on the ConsumerFinancial Protection Bureau's website.

For more information on researching,choosing, and qualifying for an affordable mortgage, see Nolo's Essential Guide to Buying Your FirstHome, by Ilona Bray, Alayna Schroeder, and Marcia Stewart (Nolo).