New rules will disqualify many for subprime ARM loans
By Matt Carter
Federal regulators have finalized new guidance on subprime lending,
instructing banks and other lenders to qualify borrowers at the fully indexed
rate, and not allow stated income and reduced documentation unless mitigating
factors "clearly minimize the need for verification of a borrower's repayment
capacity."
The guidance on
subprime lending, which applies to many adjustable-rate mortgages, also includes
consumer protections including more thorough disclosure of loan terms and limits
on prepayment penalties for borrowers seeking to refinance to avoid an interest
rate reset.
By instructing banks to qualify borrowers at the fully-indexed rate --
evaluating their ability to make monthly payments after an introductory interest
rate expires -- the guidance is likely to reduce the number of people who are
eligible for such loans.
The Mortgage Bankers Association, which has opposed new restrictions on
lenders, called the guidance "a strong statement that will help curb abuses, but
will likely also constrain consumer credit choices."
The MBA supports legislation
to modernize the Federal Housing Administration to make its mortgage guarantee
programs available to more people, but urged Congress to "refrain from passing
legislation that will further constrain credit by forcing lenders to deal with
rigid underwriting standards and litigation risk."
Some consumer groups have argued that the guidance doesn't go far enough in
restricting the use of loans with low introductory payments and penalties for
refinancing. The Center for Responsible Lending, for example, supports proposed
legislation authored by Sen. Charles Schumer, D-N.Y., the Borrower's
Protection Act. That legislation, in addition to requiring originators to
underwrite loans at the fully indexed rate, would establish a fiduciary duty for
mortgage brokers and originators and create a "faith and fair dealing" standard
for lenders.
Like guidance issued last fall for
nontraditional or "exotic" interest-only and pay-option loans, the new standards
for ARM loans only apply to banks, savings and loans, credit unions and other
lenders regulated at the federal level. Mortgage brokers, banks and non-bank
lenders regulated at the state level aren't affected unless states decide to
adopt their own versions of the guidance.
The Conference of State Bank Supervisors (CSBS) and the American Association
of Residential Mortgage Regulators (AARMR) endorsed
the subprime guidelines when they were first proposed, and are expected to
campaign for states to adopt them. So far, more than 30 states have adopted the
federal guidance for nontraditional loans.
Subprime ARM loans, which typically offer two or three years of lower
introductory interest rates, have been blamed for the recent rise in
delinquencies and foreclosures. Although touted as a way for entry-level home
buyers to buy into rapidly appreciating markets, a slowdown or reversal of home
price appreciation has left many ARM borrowers unable to refinance such loans
before their interest rates reset.
"These products originally were extended to customers primarily as a
temporary credit accommodation in anticipation of early sale of the property or
in expectation of future earnings growth," regulators said in the new guidance.
"However, these loans have more recently been offered to subprime borrowers as
'credit repair' or 'affordability' products.' "
Subprime borrowers who qualify for a loan based on a low introductory rate
may experience "payment shock" when their interest rate resets, the guidance
notes. The monthly payment on a $200,000 2/28 loan, for example, jumps from
$1,331 per month at 7 percent interest to $1,956 a month at the fully indexed
rate of 11.5 percent. Add taxes and insurance, and a borrower earning $42,000 a
year suddenly has a 62 percent debt-to-income ratio, as opposed to 44 percent at
the lower introductory rate.
The problem is compounded by the fact that many loans carry hefty prepayment
penalties for refinancing a loan to avoid the interest rate reset. The guidance
says the lenders should allow borrowers "a reasonable period of time" to
refinance their loans without penalty -- typically, at least 60 days before the
reset date.
The guidance also stipulates that prepayment penalties should not extend past
the initial reset period, although there is no expectation that lenders will
waive prepayment penalties on existing loans.
The guidance applies to ARM loans with one or more of the following features:
--Low initial payments based on a fixed introductory rate that expires after
a short period and then adjusts to a variable index rate plus a margin for the
remaining term of the loan.
--Very high or no limits on how much the payment amount or the interest rate
may increase ("payment or rate caps") on reset dates.
--Limited or no documentation of borrowers' income.
--Product features likely to result in frequent refinancing to maintain an
affordable monthly payment.
--Substantial prepayment penalties and/or prepayment penalties that extend
beyond the initial fixed interest rate period.
"Products with one or more of these features present substantial risks to
both consumers and lenders," regulators said. "These risks are increased if
borrowers are not adequately informed of the product features and risks,
including their responsibility for paying real estate taxes and insurance, which
may be separate from their monthly mortgage payments."
Although the guidance applies to subprime borrowers, regulators advise that
lenders "generally should look to the principles of this statement when such ARM
products are offered to non-subprime borrowers."
The guidance was issued jointly by the Office of the Comptroller of the
Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, the
Office of Thrift Supervision, and the National Credit Union Administration.
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