The mortgage industry is seeing a growing demand for non-qualified mortgages. These are typically quality loans that simply fall short of meeting the strict “qualified mortgage” standards set for loans that are purchased and securitized by the government-sponsored enterprises Fannie Mae and Freddie Mac.
The expanding popularity of non-qualified mortgages is a blessing for many borrowers who have not been able to qualify for a mortgage using traditional financing options. By making such alternative-financing options available to borrowers, mortgage originators have the opportunity to help many qualified borrowers and their families purchase their dream homes.
Many originators are missing opportunities in the home-finance market because they don’t fully grasp a fundamental requirement affecting all non-qualified mortgages — which is ensuring that the borrower has the ability to repay the loan. In the world of non-qualified mortgages, or non-QM, many originators are not clear on the concept of ability to repay and the characteristics that are most important to meeting the requirement.
So, how and when did ability to repay, or ATR, become the standard for the non-QM industry? It started with the Dodd–Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Barack Obama some eight years ago. The ATR standard embodied in Dodd-Frank requires lenders to make a reasonable, good-faith determination of a consumer’s ability to repay a mortgage that is secured by a dwelling for personal use — a rule that applies to qualified mortgages and non-QM loans alike.
How we got here
All owner-occupied and second-home transactions have to abide by the ATR mandate. Lenders are required to analyze borrowers’ income documentation to determine their ability to repay the mortgage. Again, it’s important to remember that properties owned for business purposes, such as investment properties, are exempt from having to conform to ATR rules and regulations.
The underlying logic of ATR with respect to homeownership is based on ensuring that borrowers are provided loans with payment terms they can afford — meaning they are conservatively calculated based on their income history over the prior 24 months. It is a common mistake for originators to use the loan-to-value ratio (LTV) as a compensating factor when evaluating the viability of a loan. Establishing a conservative LTV is a favorable factor for a lender in the case of payment default, but it is completely irrelevant to the income analysis applied to the borrower’s ability to repay.
ATR can become a particularly thorny area in the case of nonprime loans, which are a subcategory of non-QM products. The distant cousins of these higher-risk loans were called subprime loans, and prior to the housing crash 10 years ago, they commonly were offered to borrowers with a history of delinquent payments or other black marks on their credit. In fact, these so-called subprime loans were blamed for helping to spark the housing crisis — given many subprime loans at that time were prone to default because they were poorly underwritten, often relying on little to no documentation.
Many have questioned the rising popularity of nonprime loan programs, arguing that they are just another form of the subprime loans that caused so much havoc in the industry a decade ago. Those assumptions are wrong, however, because the subprime loans of that era would not pass muster under the ATR rules that non-QM loans, including nonprime mortgages, have to meet today.
Attempting to help struggling homeowners refinance their existing failing mortgage, for example, would be virtually impossible under today’s ATR standards. Think about it. How could a lender justify the transaction when the loan that is being used to refinance the failing loan and bail-out the borrower is itself proof of the borrower’s inability to repay the underlying mortgage? In order for a nonprime lender to refinance a mortgage, the borrower must demonstrate the ability to repay by bringing the existing loan current.
Another factor to consider with respect to the opportunities opened up by nonprime loans relates to bank-statement loans. Such loans have become quite attractive for self-employed borrowers who don’t have traditional paychecks and are unable to qualify for mortgages under the documented- income requirements established by agency guidelines and banks. Such bank-statement programs are of use for non-QM and nonprime loans because they allow a lender to evaluate the borrower’s bank records to establish income and to determine if there is a history of insufficient-funds notices. Too many notices of insufficient funds on bank statements, for example, point to an inability to repay because they are an indication that the borrower is unable to manage their finances.
A way forward
By applying ATR in new ways, more non-QM opportunities begin to open up. Loan programs offering a five-year fixed rate with fully amortized and indexed payments are one such opportunity, for example. A borrower may get a lower rate with a five-year fixed mortgage, but that rate is not used to determine the borrower’s ability to qualify and the maximum allowed LTV ratio.
Instead, it is common practice for lenders in underwriting the loan to assume a 2 percent increase in the rate or the fully indexed rate, whichever is higher. This more conservative approach enables originators to offer products that might seem risky in name, but actually abide by the concept of ability to repay. Interest-only loans represent another opportunity. Originators typically consider interest-only loans as a way of helping a borrower qualify by making payments lower and more affordable at the initial period of the loan. Of course, for many borrowers, these loans can prove to be the complete opposite of affordable.
A 30-year loan that features a 10-year interest-only option, for example, gives a borrower a low payment for 10 years, but for the remaining 20 years, the borrower is forced to make substantially higher payments. That’s because the borrower has a shorter period of time to pay off the entire loan after the initial 10-year interest-only option expires.
So how do non-QM lenders apply ATR to today’s interest-only loans? Simple, utilize the higher payment that begins in the 11th year of the loan to qualify borrowers and to ensure they can repay the mortgage. Of course, many borrowers today would not be able to qualify for an interest-only program under that approach — compared to the way things used to be done when subprime loans were popular prior to the housing crash.
In response, many lenders have introduced a 40-year amortized loan for interest-only programs, providing borrowers with an additional option to meet their needs. Under a 40-year amortized program with the interest-only option, the borrower would make payments on the interest for 10 years and then have 30 years remaining to pay off the loan. Compared to a 30-year interest-only loan, the payment in the 11th year would be substantially lower with a 40-year loan.
Naturally, there are many exceptions and factors to consider when determining a borrower’s ability to repay a particular loan. The overall concept, however, still boils down to ensuring responsible lending. It is about providing financing for borrowers who will be able to repay the loans today and down the road.
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By applying ATR in new ways to more loan programs, the mortgage industry can expand the non-QM environment, make more financing solutions available for more borrowers and put more people into homes they can afford — which we all want to see happen.