Ability-to-Repay rule

Key Takeaways

• The Ability-to-Repay rule requires a lender to make a reasonable, good faith determination, at or before consummation, that the borrower can repay the loan according to its terms.
• Regulation Z names eight underwriting factors, including income or assets, employment status, the new monthly payment, current debts, the debt-to-income ratio or residual income, and credit history.
• A lender must verify what it relies on using reasonably reliable third-party records, which is why a stated-income loan cannot satisfy the rule.
• An adjustable-rate loan is qualified at the greater of the fully indexed rate or the introductory rate, never at the teaser payment alone.

What It Means

The Ability-to-Repay rule is the federal underwriting standard that sits under almost every residential mortgage written today. It comes out of the Dodd-Frank Act and lives in Regulation Z at 12 CFR 1026.43, which tells a creditor it may not make a covered loan unless it makes a reasonable and good faith determination, at or before consummation, that the consumer will have a reasonable ability to repay the loan according to its terms. That determination is not a feeling about the file. Regulation Z names eight factors the lender must consider: current or reasonably expected income or assets other than the value of the dwelling, employment status when employment income is used, the monthly payment on the new loan, the payment on any simultaneous loan, mortgage-related obligations such as taxes and insurance, current debt obligations including alimony and child support, the Debt To Income Ratio or residual income, and credit history. The lender also has to verify what it relies on with reasonably reliable third-party records, which is why pay stubs, tax transcripts, and payoff statements end up in the file. A Qualified Mortgage is one route to complying, not an exemption from the duty.

How It Works in Washington

Washington does not write its own ability-to-repay test. The rule is federal, and the state's role is licensing and enforcement against the people who apply it. The Department of Financial Institutions licenses mortgage brokers and loan originators under the Mortgage Broker Practices Act, and RCW 19.146.0201(11) makes it a violation of that chapter to fail to comply with state and federal laws applicable to the activities governed by the chapter. Consumer loan companies are held to the same standard under the Consumer Loan Act, where RCW 31.04.027(1)(m) makes it a violation to violate any applicable state or federal law relating to the activities governed by that chapter. A failed ability-to-repay analysis is therefore a federal problem and a Washington license problem at once.

For a real estate broker, the practical effect shows up at preapproval. Ratio guidelines are screening tools rather than hard caps, and a file that clears them still has to survive verification. Quoting a payment built on an introductory rate sets a buyer up for a denial, because Regulation Z sends an adjustable loan to the greater of the fully indexed rate or the introductory rate, using fully amortizing payments that are substantially equal.

Example

Marisol Vega is buying a $450,000 townhome in Kent with $90,000 down, so her loan is $360,000. She earns $9,000 a month, pays $450 on a car loan and $250 on a student loan, and the lender counts $300 of property taxes and $85 of hazard insurance each month. She picks a 5/1 adjustable loan with a 5.25 percent introductory rate. The index is 4.50 percent and the Margin is 2.75 percent, so the fully indexed rate is 7.25 percent.

The lender does not qualify Marisol at the introductory payment of about $1,988. It uses the greater of the two rates, so the payment in the analysis is about $2,456. Add the $385 of taxes and insurance and the $700 of other debt, and her qualifying obligations come to $3,541 a month against $9,000 of income, a ratio of 39 percent. At the introductory payment she would have looked like 34 percent. Her file still clears, and the gap between those two numbers is what the rule is built to expose.

Common Mistakes and Exam Traps

• Ability to repay and Qualified Mortgage are not the same thing. Ability to repay is the underwriting duty on covered residential loans, while a Qualified Mortgage is a loan that meets a definition and earns the lender liability protection.
• The current general Qualified Mortgage test compares the loan's annual percentage rate to the average prime offer rate. The old 43 percent debt-to-income cap is a common but outdated answer.
• Ability to repay is a Regulation Z requirement under the Truth in Lending Act, not a RESPA requirement. RESPA governs settlement services and the closing process.
• An adjustable-rate loan is not qualified on its teaser payment. The lender uses the greater of the fully indexed rate or the introductory rate.