The Dodd-Frank Act and How It Affects You
January 10, 2014 - By Grant
The Dodd-Frank Act and the Ability-to-Repay rule
Introduced in June 2009, and signed into law by President Barack Obama on July 21 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was a response to the immediate aftermath of the 2008 financial crisis. In the years leading up to the financial crisis, lenders made too many mortgages to consumers who could not realistically pay them back. Creditors often failed to corroborate consumer’s income or debts. Lenders often engaged in loose underwriting practices, such as qualifying consumer mortgages based on teaser interest rates, which would spike monthly payments to unaffordable levels. The result of such practices was that many consumer mortgages went into delinquency and foreclosure.
In response, The Consumer Financial Protection Bureau issued an “ability to repay” rule under the Dodd-Frank Act, which requires lenders to take a more analytical and quantitative role in approving new consumer mortgages. Simply put, lenders must now determine the consumer’s ability to repay based on eight criteria:
(1) Consumers current income/assets
(2) Current employment status
(3) Credit history
(4) Monthly payment for the mortgage
(5) Monthly payments on any other mortgages
(6) Monthly payments for other mortgage-related expenses
(7) Additional outstanding debts
(8) “Debt-to-income ratio” – monthly debt payments compared to your monthly income.
Furthermore, lenders can no longer determine a consumer’s ability to repay based on “teaser” interest rates. Thus, if the loan is an adjustable-rate mortgage, the lender will have to consider the highest interest rate that the consumer may have to pay.
An important exception to the Ability-to-Repay rule is that, under certain circumstances, the rule may not apply to creditors refinancing a borrower from a riskier mortgage to a more stable one. For example, a creditor may not be able to readjust a mortgage from an interest-only loan to a fixed-rate mortgage.
New features of Qualified Mortgages
If a lender issues a Qualified Mortgage, it is assumed that the lender has met the Ability-to-Repay requirements. Furthermore, Qualified Mortgages must meet certain requirements, such as the absence of “risky” features. For example, Qualified Mortgages cannot have the following loan features:
- An “interest-only” period, when the consumer pays only the interest without paying down the principal.
- “Negative amortization” – when the loan principal increases over time, even though the borrower is making payments.
- Loan that are longer than 30 years
- “Balloon payments,” larger than usual payments near the end of the loan
Besides eliminating risky features on loans, QMs will now have a cap on how much income goes towards debt. Specifically, QMs will require that the borrower’s monthly debt is no more than 43% of the borrower’s monthly pre-tax income. However, this cap will not apply to temporarily authorized QMs for Fannie Mae/Freddie Mac, or other government agencies. A third new feature of QMs is that they will have limits, depending upon the size of the loan, on the amount of upfront points and fees that the borrower may be charged.
Overall, while some economists have expressed skepticism on the Dodd-Frank Acts ability to prevent another full-fledge financial crisis, it does provide borrowers protection from loose crediting practices. Consumers should now be more reassured about their financial ability to repay mortgages once approved. However, the Dodd-Frank Act does pose a real possibility of “freezing out” a small part of the market. For example, consumers who may have a lower credit history may find it difficult to get the necessary loan for the home they want, even if they have a solid debt-to-income ratio.