What is the Ability-to-Repay rule without DTI?

What is DTI?

DTI has not always been a requirement for mortgage underwriting. In fact, it is a more recent evolution of the mortgage origination process, one that began with the inception of the Ability-to-Repay rule.

Through the Dodd-Frank Wall Street Reform and Consumer Protection Act, created by Congress in 2010, the Ability-to-Repay rule was born. The CFPB defines the rule as the reasonable and good faith determination most mortgage lenders are required to make that consumers are able to pay back the loan.

“Under the rule, lenders must generally find out, consider, and document a borrower’s income, assets, employment, credit history and monthly expenses,” the bureau states. “Lenders cannot just use an introductory or ‘teaser’ rate to figure out if a borrower can repay a loan. For example, if a mortgage has a low interest rate that goes up in later years, the lender has to make a reasonable effort to figure out if the borrower can pay the higher interest rate too.”

Part of the Ability-to-Repay rule includes, among many other factors, a review of a borrower’s debts and assets to ensure they have the ability to repay the loan, with a stipulation that their DTI ratio does not exceed 43%.

But Fannie Mae and Freddie Mac are not bound to this requirement, a condition known as the QM Patch. Under the QM Patch, loans sold to Fannie Mae or Freddie Mac are allowed to exceed the 43% DTI ratio.

“Because loans made under the ability to repay test would require a very intensive underwriting approach and there would be a lot of legal risk, they created a ‘qualified mortgage’ safe harbor for loans that should be considered properly underwritten and reasonably safe,” said Jeffrey Naimon, partner in the Washington, D.C., office of Buckley.

It was intended to be a temporary fix, to last just until Fannie Mae and Freddie Mac exited conservatorship, Naimon explained. No one predicted that 12 years later, the mortgage giants would still be under the control of the Federal Housing Finance Agency.

An analysis from Pete Carroll, CoreLogic government affairs team as executive, public policy and industry relations, shows that a full $260 billion, or 16% of total loan origination volume in 2018, was QM eligible based solely on the GSE QM Patch.

But many in the housing industry have stated that this gives the GSEs an unfair advantage. Even FHFA Director Mark Calabria stated this, saying that loans sold to them did not have to play by the same rules as everyone else.

“We welcome Director Kraninger’s announcement that CFPB’s proposed rule will not rely solely on DTI to determine whether a borrower is able to receive QM protections,” said Eric Stein, Center for Responsible Lending subsidiary Self-Help senior vice president. “While DTI is relevant in assessing a borrower’s ability to repay their loan, it is by no means the only factor and thus should not be the only factor in determining whether or not loans should be considered QM.”

But the QM Patch is set to expire in January 2021, and Kraninger must decide what to do when it’s gone. The CFPB is also considering extending the deadline for the expiration of the QM Patch for an undetermined period of time as it weighs various replacement options.

Kraninger’s letter states that the GSE Patch will be extended either until the CFPB finds an alternative, or the GSEs exit conservatorship, but the CFPB expects to issue its new rule no later than May 2020.

And while Kraninger does suggest that legislation could better accomplish clarifying the rules on QM loans, efforts to do so have stalled out in Congress so far, so the CFPB is taking matters into its own hands.

“While the Bureau is moving forward expeditiously to address the upcoming expiration of the GSE Patch, we recognize that legislation could better accomplish important policy objectives, such as providing clarity on what qualifies as a QM loan, leveling the playing field among lenders and ensuring consumers continue to have access to credit,” Kraninger wrote.

Alternative options

“The CFPB was enormously clear in all of their interactions that they aren’t going to stay with the GSE patch,” Naimon said. “They’re going to go into something different.”

In her letter to Congress, Kraninger proposes using a pricing threshold, rather than DTI, to determine ability to repay – a move that many advocates in the housing industry are on board with.

“Our view is a standalone DTI measure is really imperfect, particularly as just a sole factor for determining what a QM and what’s not a QM,” said Pete Mills, Mortgage Bankers Association senior vice president of residential policy and member engagement.

In the method the CFPB is proposing and the MBA and other housing organizations also support, originators would look at the difference between the loan’s annual percentage rate and the average prime offer rate for a comparable transaction. If the prime rate, released weekly by Freddie Mac in its Primary Mortgage Market Survey, is 4%, originators could then originate a loan that is no more than 150 basis points from that rate.

Mills explained that when using this method, analysis has shown it is a much better determining factor to delinquency risk than measuring DTI.

“It’s an indirect measure of repayment ability,” Mills said. “It includes other credit factors, it includes collateral risk, it includes credit risk and repayment risk. But it does serve as a good overall measure of repayment ability.”

Naimon also explained that one of the advantages advocates have stated in favor of using a pricing threshold is that the line would be clear on what is QM and what isn’t, and it would be easier for auditors to see at-a-glance if a loan should be considered QM.  

However, there are also concerns with this method. Naimon explained that if a borrower were close to meeting the pricing threshold, such as 15 basis points away, some have raised concerns that lenders might be able to manipulate their pricing in order to get the consumer into a QM and secure the mortgage, rather than turning away the borrower.

In comment letters to the CFPB, insurance companies pressed against the pricing threshold option. USMI suggested that the CFPB develop a single set of transparent compensating factors for loans with DTIs above 45% and up to 50% for defining QM across all markets, similar to how the GSEs, FHA and VA use compensating factors in their respective markets today.

USMI also suggested that the bureau maintain the ATR and product restrictions as part of any updates to the QM definition to ensure discipline in the lending community. This would protect consumers and retain specific underwriting guardrails such as the current DTI component of the QM definition but modifying the specific threshold to better serve consumers.

Why lenders avoid non-QM

There is fear that if originators are allowed to return to the “wild west” of the pre-crisis era, borrowers will once again be placed into loans that they can’t afford.

Before the housing crisis, the non-QM market had a much larger share, which even caused Fannie Mae and Freddie Mac to begin losing some of their market share. Now, the FHFA is discussing the possibility of allowing new entrants into the market to compete with Fannie Mae and Freddie Mac, that competition is not likely to come from non-QM lenders.

That’s because while the rise of non-QM originators is certainly something to keep an eye on, there are several reasons why lenders often prefer to avoid the non-QM market.

One reason lenders avoid it is because of the threat of litigation. Because of the fact-specific findings that would be necessary to resolve this kind of case, it is expected that lenders will not be able to file for a motion to dismiss when cases are filed against them. If a borrower goes into default and takes the lender to court, citing the Ability-to-Repay rule, even a simple case could take years to work through, Naimon explained.

There has also been a drastic increase in regulation since the housing crisis began in 2008. The DTI requirement is just one of many factors lenders look at in order to determine a borrower’s eligibility for a mortgage, and according to the MBA, an unnecessary factor.

While DTI might be the only factor in the Ability-to-Repay rule that technically looks at income (hence, the borrower’s actual ability to repay the mortgage), other variables might be a better ways to determining if they will repay it.

There is also not a significant need for non-QM in the housing market at this point. The greatest problem in the housing market today is the shortage of homes for sale,  not a shortage of credit availability.

And lenders even have room to expand their credit within the QM market. MBA’s Mortgage Credit Availability Index rose 2.1% to 188.9 in November, indicating a loosening of credit standards. However, it was close to the 11-year high of 189.5 in June, the trade group said in a recent report. November’s reading was the third-highest reading of the post-crash years.

Many housing industry experts have repeatedly asked the CFPB to do away with the QM rule’s DTI ratio requirement. While the CFPB is taking steps in that direction, it remains to be seen what new option will replace DTI.