Regulation Z, Ability-to-Repay, and ARMs

Issue/Inquiry

The Bank would like to know if there are specific rules for calculating the consumer’s ability to repay when there is an adjustable rate mortgage. If the mortgage loan will include multiple interest rate adjustments over the term, at what rate does the Bank qualify the customer?

Response Summary

In determining the consumer’s Ability to Repay (“ATR”), the monthly payment is generally calculated using the fully indexed rate or any introductory rate, whichever is greater, and the fully amortizing payments that are substantially equal. For an Adjustable Rate Mortgage (“ARM”), “fully indexed” means the index rate at consummation plus the margin. ARMs are considered “nonstandard” mortgages and may be refinanced into “standard” mortgages when the loan recasts.

Response Detail

Under Regulation Z, lenders are required to consider at least the following eight factors in the underwriting of closed-end consumer loans secured by a dwelling:

• Current or reasonably expected income or assets
• Current employment status
• The monthly payment on the covered transaction
• The monthly payment on any simultaneous loan
• The monthly payment for mortgage-related obligations
• Current debt obligations, alimony, and child support
• The monthly debt-to-income ratio or residual income
• Credit history

These “Ability to Repay” or “ATR” rules do not mandate specific underwriting standards, but lenders are required to develop standards based on their own unique experience and circumstances, which take these factors into consideration. Official Interpretations, 1026.43(c)(2) – 4.

As a general rule, the consumer’s monthly payment on the covered transaction must be calculated using:

• The fully indexed rate or any introductory rate, whichever is greater
• Monthly, fully amortizing payments that are substantially equal, 12 CFR §1026.43(c)(5)(i)

In applying this formula to the calculation of the consumer’s monthly, fully amortizing payments for an ARM, the “fully indexed rate” means the index value at consummation plus the margin. If the index is 4.5 percent at consummation and the margin is 3 percent, the fully indexed rate would be 7.5 percent. This is the rate that would be used in calculating the monthly payments that will amortize the outstanding balance over the term of the loan, assuming that it is greater than any introductory rate. Official Interpretations, 1026.43(c)(5)(i) – 5.ii.

If the introductory rate for an ARM is a premium rate that is greater than the fully indexed rate, the premium rate will be used in calculating monthly, fully amortizing payments.  Official Interpretations, 1026.43(c)(5)(i) – 2.

There are special rules for balloon payment, interest-only, and negative amortization loans, of which the first two types will be discussed in this response. For a loan with a balloon payment, the calculation must consider:

• The maximum payment scheduled during the first five years after the date the first regular periodic payment will be due (provided the loan is not a higher-priced covered transaction)
• The maximum payment in the payment schedule, including any balloon payment, for a higher-priced covered transaction, 12 CFR §1026.43(c)(5)(ii)(A)

For an interest-only loan, the calculation will be based on:

• The fully indexed rate or any introductory rate, whichever is greater
• Substantially equal, monthly payments of principal and interest that will repay the loan amount over the term of the loan remaining as of the date the loan is recast, 12 CFR §1026.43(c)(5)(ii)(B)

For both balloon payments and interest-only loans, the calculation will use the fully indexed rate of interest or any introductory rate, whichever is greater. Official Interpretations, 1026.43(c)(5)(i) – 1.

The official commentary provides examples of ARMs which may have interest-only periods or periods when the rate of interest is discounted:

• For an ARM with a 30-year term and a fixed rate of interest for the first five years, the calculation of the monthly payment will be based on the fully indexed rate or the rate for the initial five years, whichever is greater, amortized over the 30 year-term of the loan. Official Interpretations, 1026.43(c)(5)(i) – 5.ii.

• For an ARM with a term of 30 years, a fixed rate of interest for three years, and interest-only payments for five years, the calculation of the monthly payment will be based on the fully indexed rate or the rate for the initial three years, whichever is greater, amortized over the 25 years remaining as of the date the loan is recast. Official Interpretations, 1026.43(c)(5)(ii)(B) – 2.ii.

Under certain circumstances, a creditor may be able to refinance a non-standard loan that a consumer may not be able to afford when it recasts without considering the eight underwriting factors under the ATR rules. A “non-standard” loan is:

• An ARM with an introductory fixed interest period of one year or longer
• An interest-only loan
• A negative amortization loan. 12 CFR §1026.43(d)(1)(i)

This option can only be used when:

• The refinance will not cause the consumer’s principal balance to increase.
• The consumer uses the proceeds only to pay off the original mortgage and for closing costs.
• The consumer’s monthly payment will materially decrease by at least 10 percent.
• The consumer has had only one 30-day late payments in the last 12 months and no late payments within six months.
• The consumer’s written application for the standard mortgage is received no later than two months after the non-standard mortgage has recast.
• The standard mortgage will likely keep the consumer from defaulting on the non-standard mortgage.
• If the non-standard mortgage was consummated after January 10, 2014, it was made according to the ATR rules. 12 CFR §1026.43(d)(1)(ii)(A).

When comparing the payments of the non-standard to the standard mortgage, the payments for the non-standard mortgage are calculated when they reach the recast point. For an ARM, this is when the introductory fixed-rate period ends. The amount of the loan will be the amount of principal outstanding when the loan recasts, assuming that any principal payments due from the consumer will have been made by that time. 12 CFR §1026.43(d)(5).

This entry was posted on Monday, October 23rd, 2017 at 6:00 am.