New mortgage regulations go into effect Friday that aim to keep buyers from getting into loans they can’t afford.
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This new class of loans, called Qualified Mortgages (QM), prohibit interest-only and negatively amortizing loans and limits the amount of points -- fees or prepaid interest on a mortgage -- to 3% of a loan’s value.
“These new regulations are designed to prevent what happened in the housing bubble from happening again,” says Jed Kolko, chief economist at Trulia. “Those toxic mortgages that we saw in the last decade fall outside these rules.”
Lenders will also be required to verify that borrowers have the ability to repay their loan. The ability-to-repay rule says lenders must assess and document a potential home buyer’s income and assets, employment status, credit score and other outstanding debt levels before issuing a loan.
• Cannot have excessive upfront points and fees;
• Cannot be longer than 30 years;
• Cannot have certain risky features, such as paying only interest and not principal, or paying less than
the full amount of interest so that the total debt grows each month;
• Must be in one of three categories:
1. The monthly loan payment, plus the borrower’s other debt payments, does not exceed 43% of the borrower’s monthly income; or
2. The loan qualifies for purchase or guarantee by a government sponsored enterprise (Fannie
Mae or Freddie Mac), or is insured or guaranteed by a federal housing agency; or
3. The loan is made by a small lender that keeps the loan in portfolio.
To be considered a qualified mortgage, the loan amount cannot exceed a total debt-to-income ratio of 43%.
“The test here is that you have to be able to show the client’s ability to repay the loan and that your analysis was sufficient enough [to show] the client has the ability to repay the loan today and going forward to the best of their ability,” says Mike McPartland, head of investment finance at Citi Private Bank.
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The rules were created by the Consumer Financial Protection Bureau and were mandated under the Dodd-Frank Act to ban many of the practices that led to the housing bubble burst in 2008.
“If these laws were in place in the years leading up to 2007, I don’t think the collapse, to the extent that we saw, would have happened,” says Kolko.
Mortgages that could qualify to be bought by mortgage giants Fannie Mae or Freddie Mac or other government agencies must also meet qualified mortgage standards. Lenders are not restricted to just offering these loans, but when issued, QMs can help protect lenders from lawsuits claiming unfair or deceptive lending practices.
“There is an implied safety here and my sense is that it would be useful in a default defense,” says McPartland. “Lenders will now be able to say that they met the standards. Although there has been no indication from regulators that those loans will be guaranteed --it’s probably a sound defense.”
The housing market has been championed as the backbone to the economic recovery, but low inventory and tight lending standards have remained a drag on the sector. Some experts worry the new standards could negatively impact an already-nervous mortgage market.
Polyana da Costa, senior mortgage analyst at Bankrate.com, says the majority of home buyers won’t be impacted by the rules, and the CFPB estimates that at least 95% of mortgages meet these new standards.
“Underwriting standards have already been tightened a lot in recent years. I don’t think you are going to see a major change in the lending standards and a pullback in loans issued,” says da Costa.
That said, she does expect some market disruption in the weeks following Friday’s rollout.
“Lenders might be more conservative for the first few weeks with their underwriting process, but that’s because it’s new to everyone and no one wants to get caught doing something wrong. They are going to be anxious at first, but then it will be business as usual.”
In fact, Kolko says the new rules could spur more lending and ease the credit freeze.
“In the past, lenders have suggested the lack of clarity around their legal risks have prevented them from lending more. These rules provide the standards. And with mortgage rates on the rise and refinancing activity slowing, we could be seeing banks being ready to issue more loans.”
The fact that nearly all mortgages issued today meet the QM standards doesn’t sit particularly well with Chris Polychron, president-elect of the National Association of Realtors. “The 90% number sounds real good, but when the average credit score of the borrowers being 757, that is real tight, there are a lot of people sitting around that don’t have that number and are being excluded from getting into the market.”
He says private capital needs to get re-established as part of the competitive mortgage market to help generate more lending.
Buyers seeking jumbo mortgages, which are loans that exceed the conforming loan limit -- which is $417,000 in most areas of the country -- could feel the brunt of the new rules. “It depends on where the borrower lands relative to the rules with the debt-to-income ratio,” says Kolko. “People with a lot of debt relative to income might find it harder or more expensive to get that mortgage.”
Smaller financial institutions could also end up being squeezed by the 3% cap rule, according to Polychron. He explains that big banks can generate 3% in total fees on the mortgage and then send the client to an outside title company which will also be able to add on fees without "unqualifying" the mortgage. However, a smaller real estate company that also includes a mortgage and title division has to keep all their fees under that 3% cap. “They won’t be able to write the title because they can’t make that charge and they won’t be able to stay in business,” Polychron says.
Cameron Findlay, chief economist at Discover Home Loans, says the 3% cap could also hurt lower- to moderate-income homebuyers with poor credit quality to qualify for a QM. He expects 10-12% of potential buyers not to qualify under the new rules.
“The pricing grids mandated by the government are driving disqualifications for these buyers. The 3% points and fees limit mandates certain loan pricing adjustments be applied to specific FICO scores and loan to value that can make qualification unattainable.”