Understanding the Ability-To-Repay Rule

The ability-to-repay (ATR) rule requires mortgage lenders to verify that borrowers will be able to repay their mortgage loans. Lenders must verify this when underwriting a new residential mortgage. This article explains when mortgage lenders are required to use the ATR rules, how the ATR rules are applied, and the legal remedies for violations of the ATR rules.

The Ability-To-Repay Rule

The housing crisis of 2008 was primarily caused by lenders underwriting loans to borrowers who couldn't afford to make the mortgage payments. The government created the ability-to-repay (ATR) rule to prevent a future foreclosure crisis. The rule requires mortgage originators to make reasonable, good-faith efforts to determine if borrowers will be able to repay loans. 

If the lender offers a lower introductory interest rate, it can't only verify a consumer’s ability to pay based on that rate. It has to verify that the borrower can pay once the higher rate and monthly payments kick in. To do this, creditors must look at the borrower's income, employment, assets, monthly expenses, and credit history.

The ATR rule was created by the Consumer Financial Protection Bureau (CFPB), and it’s part of Regulation Z and the Truth in Lending Act. The rule applies to most closed-end mortgages. Most first mortgages on a home are closed-end because they have a specific pay-off date. Open-ended mortgage loans like home equity lines of credit (HELOCs) aren't covered by the ATR rules.

Qualified Mortgages Are Assumed To Be in Compliance

Lenders can make a qualified mortgage (QM) to ensure they are following the ATR. There are four types of qualified mortgages, but the most common is a general qualified mortgage.

General qualified mortgages must meet the following requirements:

• The mortgage can't have negative amortization. This is when you make payments, but they aren't enough to cover even the interest due each month. As a result, your principal increases instead of decreases with each payment.

• There can be no interest-only period.

• There can be no balloon payment.

• The loan term can't be more than 30 years.

As a reward for the loan not having these characteristics, the lender is presumed to have been in compliance with the ATR rules if challenged in court. This is sometimes called having a safe harbor. The lender is presumed to be in compliance with Regulation Z and will be able to rely on the safe harbor if the borrower sues.

How the ATR Rule Is Applied

There are eight factors lenders must consider to make a reasonable, good-faith determination that you're able to repay the loan.

1. Lenders have to consider your assets and income.

Lenders have to look at your current and reasonably expected income from employment and/or other sources. Other sources might include self-employment income, military reserve income, interest and dividends, retirement income, and more. Any type of incoming money is considered for income purposes. They have to look at all your assets except the home you’re purchasing. This includes but isn’t limited to retirement accounts, savings accounts, checking accounts, and/or money from a trust. 

Lenders don’t have to consider both income and assets if one will support your ability to pay the mortgage. Lenders have to verify this information using third-party documentation like pay stubs or brokerage account statements.

Lenders also have to consider your reasonable expected future income. They can again use third-party records to get evidence of future income. For example, if you want to include future raises in the calculation of your expected income, the lender can check with your employer and get evidence of past raises and the expectation of future wages.

2. Lenders must verify your employment income.

If the lender relies on employment income to prove your ability to pay, then the lender will have to verify your employment status. You don't have to be a full-time employee to qualify. If being a seasonal employee or part-time employee is enough to show that you can afford to make the required payments, that will be enough.

The lender doesn't have to verify employment if there is enough income from other sources to meet the Regulation Z requirements. For example, if you have sufficient income from rental properties or dividend income, then the lender doesn't have to verify your employment.

3. Lenders must calculate your monthly mortgage payment.

The lender must calculate your monthly mortgage payment. If your loan has an adjustable rate or stepped rate mortgage and your monthly payments may change substantially over the life of the loan, the calculated payments need to reflect the monthly payment under the highest interest rate.

4. Lenders must consider other loans that will be secured by the same property.

The lender must consider other loans that will be secured by the same property. These are loans like HELOCs that the lender knows or has reason to know will be made. The payment on these other loans will be calculated. You'll have to be able to prove you have the ability to repay the other loan along with the loan you're applying for.

5. Lenders must consider other mortgage-related obligations.

The lender will have to estimate other obligations you’ll have like property taxes, insurance, and HOA fees. The lender doesn't have to estimate things that are impossible to predict, such as possible changes in the property tax rate.

6. Lenders must consider your other current monthly debt obligations.

Examples of monthly debt obligations include alimony child support, student loans, car loans, credit card debts, and personal loans. Lenders need to check any other liabilities that require payments that might interfere with your ability to make payments on your new mortgage. If you have an existing mortgage that will not be paid off at or before the closing of the mortgage you're applying for, the lender has to consider the monthly payments on that mortgage.

7. Lenders must consider your debt-to-income ratio (DTI) or your residual income.

The lender will compare the amount of debt payments you have to make each month with the amount of income you make. Debt includes all your current monthly debt payments, plus the calculated monthly payments on the mortgage loan you're applying for and any other loans that will be secured by the property. 

To calculate your DTI, the lender divides your total monthly debt payments by your monthly income from all sources. Before December 2020, your DTI couldn’t be more than 43% under the ATR rule. This has been replaced by a new rule called a price-based approach. This approach requires the annual percentage rate not to exceed the average prime offer rate for comparable first liens by 2.25 percentage points, or more for loan amounts greater than $100,000, indexed for inflation. For loan amounts less than $100,000 (currently $110,260 as indexed), the threshold is up to 6.5 percentage points for first liens. For junior liens, it’s 3.5 percentage points and up to 6.5 percentage points for smaller subordinate loans.

Lenders can use your monthly residual income instead of your DTI. Your monthly residual income is calculated by subtracting your total monthly debt payments from your total monthly income from all sources. This leftover income is the monthly residual income.

8. Lenders must consider your credit history.

While your credit score often matters in the lending process, here it’s irrelevant. There is no minimum credit score to show your ability to repay. Instead, the lender is to look at the following factors on your credit report:

• Number of lines of credit

• Age of credit lines

• Payment histories

• Collection accounts

• Any judgments

• Any bankruptcies

The ATR rules allow the lender to consider all eight factors mentioned above, plus any other factors the lender may be aware of.

Exemptions to the ATR Rule

Some loans don’t have to comply with the CFPB's ATR rule. If you refinance with a non-standard loan, it will be exempt from the ATR requirements. Non-standard loans include:

• Interest-only loans,

• Negative amortization loans, and

• Adjustable-rate mortgages with an introductory fixed-rate interest for one year or longer

If you refinance one of these mortgages with a standard mortgage, the lender must determine your risk of defaulting.

Some organizations are also exempt from the ATR requirements, including: 

• Creditors that have been designated as Community Development Financial Institutions,

• Creditors designated as a Downpayment Assistance through a Secondary Financing Provider

• Creditors designated as Community Housing Development Organizations

• Some non-profit organizations

The remaining loans that are exempt from the ATR requirements are loans with short terms, open-ended loans, and loans that won't cause you to lose your primary residence if you lose your ability to pay. These types of loans include:

• Any open-ended credit plans secured by the home, such as a HELOC

• Reverse mortgages

• Mortgages secured by timeshare plans

• Bridge loans with terms of 12 months or less, with the possibility of renewal

• Construction phase loans of 12 months or less, with the possibility of renewal

• Consumer credit loans secured by a vacant lot

Legal Remedies for ATR Rule Violations

If you fall behind on your mortgage payments, you may be able to sue the lender for failing to make a good-faith determination of your ability to pay. This only applies if you fall behind without good reason, such as an illness or job loss. Under these circumstances, it’s a good idea to contact a consumer attorney. In this article, we've only touched on the surface of how complex the ATR/QM rules can be. The lender needs to be able to show that it followed the rules, which can get very messy if it didn’t make a qualified mortgage loan. 

Lenders can be liable for penalties, damages, and attorney's fees for failure to follow the ATR rules. There is a  three-year statute of limitations on bringing these lawsuits. In other words, if you're suing for violation of the ATR rules, you must do it within three years of being approved for the loan. If a lender failed to follow the ATR rules and you’re now facing foreclosure, you may be able to use this as a foreclosure defense. When used as a defense, there's no statute of limitations.

Let’s Summarize…

Congress implemented the ability-to-repay rule to make sure lenders aren’t making loans that doom borrowers to eventual foreclosure. Under the ATR rule, lenders must make a reasonable, good-faith determination that borrowers will be able to repay their mortgage loans. To determine this, lenders will look at your assets, income, employment, credit history, ongoing expenses, and debt obligations. Lenders can also consider any other factors that could affect your repayment ability. If you have difficulty paying your mortgage that’s not related to a major change in your life circumstances, you may be able to bring a legal claim against the lender for violating the ATR rule.