Further Dodd-Frank Implementation: Federal Reserve Board Proposes New Rules Regarding Consumer’s Ability to Repay

The Federal Reserve Board has issued a proposed rule for public comment that would require creditors to determine a consumer’s ability to repay a mortgage before making the loan and would establish minimum mortgage underwriting standards. In reviewing and commenting on the elements of the proposal, industry and consumers alike hope that the FRB establishes reasonable protections for consumers without unduly burdening creditors or restricting consumers’ access to mortgage credit.  

As you will recall, amendments to the Truth in Lending Act (TILA) made under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) prohibit a creditor from originating any closed-end consumer credit transaction secured by a dwelling (other than a timeshare, reverse mortgage or temporary loan) without regard to the consumer’s ability to repay the loan. The proposal is an expansion of TILA’s current requirements that apply to certain higher-priced mortgage loans.  

Pursuant to Dodd-Frank, the proposal provides four options for complying with the ability-to-repay requirement.  

General Ability To Repay Standard—A creditor may meet the general ability-to-repay standard by considering and verifying eight specified underwriting factors, such as the consumer’s income or assets, employment status, and income ratio.  

Qualified Mortgage—A creditor may make a "qualified mortgage," which provides the creditor with special protection from liability, provided (i) the loan does not have certain features, such as negative amortization; (ii) the fees are within specified limits; and (iii) the creditor underwrites the mortgage payment using the maximum interest rate in the first five years. The Board is soliciting comment on two alternative approaches for defining a "qualified mortgage," as discussed below.  

Balloon Payment Qualified Mortgage—A creditor operating predominately in rural or underserved areas may make a balloon-payment qualified mortgage, with a loan term of five or more years by complying with the qualified mortgage requirements and underwriting the loan based on the regularly scheduled payment. This option is meant to preserve access to credit for consumers located in rural or underserved areas where creditors originate balloon loans to hedge against interest rate risk for loans held in portfolio. 

Refinancing of Non-Standard Mortgage—A creditor may refinance a "non-standard mortgage" with risky features into a more stable "standard mortgage" with a lower monthly payment. This option is meant to preserve access to streamlined refinancings. 

The FRB is soliciting comment on two alternative definitions of a "qualified mortgage" in connection with option 2 above. The first alternative would create a legal safe harbor and define a "qualified mortgage" as a mortgage for which: (i) the loan does not contain negative amortization, interest-only payments or a balloon payment, or a loan term exceeding 30 years; (ii) the total points and fees do not exceed 3 percent of the total loan amount; (iii) the income or assets relied upon in making the ability-to repay determination are considered and verified; and (iv) the underwriting of the mortgage (1) is based on the maximum interest rate that may apply in the first five years, (2) uses a payment scheduled that fully amortizes the loan over the loan term, and (3) takes into account any mortgage-related obligations. 

The second alternative definition would create a rebuttable presumption of compliances with the ability to repay requirement and would define a "qualified mortgage loan" as a mortgage that: (i) satisfies the criteria in the first alternative above, and (ii) for which the creditor verifies and takes into account the consumer’s employment status, monthly payment for any simultaneous mortgages, the consumer’s current debt obligations, the monthly debt-to-income ratio or residual income and the consumer’s credit history. 

The proposal would also implement Dodd-Frank’s limits on prepayment penalties (which, under certain circumstances, permit a fixed rate qualified mortgage to include a penalty for prepayment within the first three years of the loan term). The proposed rules also lengthen the time creditors must retain records that evidence compliance with the ability to repay and prepayment penalty provisions to three years after the date of loan consummation. 

The Board is soliciting comment on the proposed rule until July 22, 2011. General rulemaking authority for TILA is scheduled to transfer to the Consumer Financial Protection Bureau on July 21, 2011. Accordingly, this rulemaking will not be finalized by the Board.

Should you have any questions about this regulatory change or need additional information, please contact Richard E. Gottlieb, Director of the Firm's Financial Industry Group, at 312-627-2196, or Arthur B. Axelson the author of this alert and leader of the Firm's regulatory compliance practice, at 202-906-8607.

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