What Is the Ability to Repay?
The ability to repay refers to an individual’s financial capacity to make good on a debt. In particular, the phrase “ability to repay” was used in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. It describes the requirement that mortgage originators substantiate that potential borrowers can afford the mortgage. This provision of Dodd-Frank is often called the ability-to-repay rule, and “ability to repay” is sometimes abbreviated as ATR.
Under Dodd-Frank, the Consumer Financial Protection Bureau (CFPB) has jurisdiction to create new rules and regulations for the mortgage industry. According to these rules, the loan originators must look at a borrower’s total current income and existing debt. They need to make sure that the existing debt, plus the potential mortgage debt and related expenses, do not exceed a stated percentage of the borrower’s income.
Key Takeaways
- The ability to repay is one’s ability to repay debts and obligations.
- The ability-to-repay rule is the part of the Dodd-Frank Wall Street Reform and Consumer Protection Act that restricts loans to borrowers who are likely to have difficulty repaying them.
- Factors considered in the ability to repay include the borrower’s income, assets, employment status, liabilities, credit history, and the debt-to-income (DTI) ratio.
- As of early 2020, the Consumer Financial Protection Bureau (CFPB) was planning to eliminate the debt-to-income requirements.
History of the Ability-to-Repay Rule
The ability-to-repay rule was included as a response to the mortgage crisis in 2008. Before then, lenders could provide mortgages to homebuyers whose incomes did not demonstrate the ability to pay the monthly mortgage payments. That led to the housing bubble of the 2000s and the mortgage crisis. In the end, a large number of homes faced foreclosure at the same time. Under the new mortgage regulations stipulated by the CFPB, individuals who are not held to the ability-to-repay standard during the origination process may have a defense against foreclosure.
The ability-to-pay rule is a cornerstone of financial stability, according to a paper in The Georgetown Law Journal. Without it, loan-to-value limits are not enough to curb property bubbles. Although loan-to-value limits are important to constraining risk, the denominator—the value—will become artificially elevated during a bubble and will only fall after the bust is under way, shrouding the elevated default risk at origination and giving false confidence that mortgage risk is contained. The mortgage crisis demonstrated that the inability to repay exacerbates default risk, the paper said, along with the resulting further depression in housing prices.
Requirements of Ability to Repay
The CFPB specifies eight factors that determine whether a borrower demonstrates the ability to repay. Based on these standards, the lender makes a reasonable and good-faith decision about the borrower’s ability to repay the loan.
The factors used to determine the ability to repay include the borrower’s current income and assets. They may also include reasonably expected income. The borrower must also provide verification of this income and their employment status.
Besides income, lenders must consider a borrower’s current liabilities. That includes any outstanding debts that they are still paying, as well as child support and other monthly payments. A lender will also check a borrower’s credit history.
Previously, lenders were asked to consider a borrower's debt-to-income (DTI) ratio to make a final determination. But as of December 2020, the DTI requirements of the ability-to-repay rule have been eliminated and replaced with a price-based approach, with the CFPB noting that a loan’s price is a strong indicator of a consumer’s ability to repay.
The move to eliminate DTI requirements came in part because of industry criticism of an existing exemption from DTI rules for loans backed by Fannie Mae and Freddie Mac.
Just because borrowers can get loans under easier rules does not mean that they should. Relatively high home prices in 2020 and the large number of bankruptcies related to the 2008 financial crisis suggest caution.
Exceptions to the Ability-to-Repay Rule
Several types of mortgages are exempt from the ability-to-repay rule. Some of these loans include timeshare plans, home equity lines of credit, bridge loans, a construction phase of less than a year, and reverse mortgages.
Loans backed by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, are exempt from debt-to-income requirements. This exemption is called the GSE patch or the qualified mortgage (QM) patch. According to the Independent Community Bankers of America (ICBA), the patch applied to 25% or more of GSE loans as of early 2020. However, the patch will expire on July 1, 2021, or the date when Fannie Mae and Freddie Mac exit conservatorship, whichever happens first. The new rules regarding ability to pay will replace the existing patch.
FAQs
pursuant to certain programs, certain nonprofit creditors, and mortgage loans made in connection with certain Federal emergency economic stabilization programs are exempt from ability to repay requirements.
What are the documentation requirements for ability to repay? ›
Under the rule, lenders must generally find out, consider, and document a borrower's income, assets, employment, credit history, and monthly expenses. Lenders cannot just use an introductory or “teaser” rate to figure out if a borrower can repay a loan.
Which of the following loan transactions would be exempt from tila disclosure requirements? ›
The Truth in Lending Act (and Regulation Z) explains which transactions are exempt from the disclosure requirements, including: loans primarily for business, commercial, agricultural, or organizational purposes. federal student loans.
What are the 8 borrower considerations according to the ability to repay standards? ›
At a minimum, creditors generally must consider eight underwriting factors: (1) current or reasonably expected income or assets; (2) current employment status; (3) the monthly payment on the covered transaction; (4) the monthly payment on any simultaneous loan; (5) the monthly payment for mortgage-related obligations; ...
Which of the following type of loans are exempt from Regulation Z's right to rescind? ›
Certain types of loans are not subject to Regulation Z, including federal student loans, loans for business, commercial, agricultural, or organizational use, loans above a certain amount, loans for public utility services, and securities or commodities offered by the Securities and Exchange Commission.
What is an exempt loan? ›
Lenders using tax exempt loans are not required to pay taxes on the interest income from the loan which enables them to offer lower interest rates to the borrower. Tax exempt loans are limited to eligible borrowers which include manufacturers, first time farmers, and 501c3 organizations.
What are the factors that may affect the borrowers' ability to repay? ›
Factors considered in the ability to repay include the borrower's income, assets, employment status, liabilities, credit history, and the debt-to-income (DTI) ratio.
Which of the 5 C's of credit help determine the ability to repay a loan based upon incoming and outgoing cash flow? ›
Capacity – This is the businesses ability to repay the loan. Lenders will look at revenue, expenses, cash flow and repayment timing as well as business and personal credit scores.
What are the three C's used in determining a person's willingness and ability to repay debts? ›
Character, capital (or collateral), and capacity make up the three C's of credit. Credit history, sufficient finances for repayment, and collateral are all factors in establishing credit. A person's character is based on their ability to pay their bills on time, which includes their past payments.
What are the exemptions from TILA? ›
But there are exemptions. The following loans aren't subject to Regulation Z laws: Federal student loans. Credit for business, commercial, agricultural or organizational use.
The TILA-RESPA rule applies to most closed-end consumer credit transactions secured by real property, but does not apply to: HELOCs; • Reverse mortgages; or • Chattel-dwelling loans, such as loans secured by a mobile home or by a dwelling that is not attached to real property (i.e., land).
Which loans don't require TILA disclosure? ›
What Is Not Covered Under TILA? THE TILA DOES NOT COVER: Ì Student loans Ì Loans over $25,000 made for purposes other than housing Ì Business loans (The TILA only protects consumer loans and credit.)
What loans are exempt from ability to repay? ›
August 14, 2013 2.0 Exemptions: Creditors with certain designations, loans pursuant to certain programs, certain nonprofit creditors, and mortgage loans made in connection with certain Federal emergency economic stabilization programs are exempt from ability to repay requirements.
What are the 5 C's of borrowers? ›
The five C's, or characteristics, of credit — character, capacity, capital, conditions and collateral — are a framework used by many lenders to evaluate potential small-business borrowers.
What is the ATR and QM rule? ›
The Ability-to-Repay/Qualified Mortgage Rule (ATR/QM Rule) requires a creditor to make a reasonable, good faith determination of a consumer's ability to repay a residential mortgage loan according to its terms.
What loan types are exempt from Hoepa rules? ›
The HOEPA excluded residential mortgage transactions (defined as a mortgage to finance the acquisition or construction of a principal dwelling, commonly known as a purchase-money mortgage);5 reverse mortgages; and open-end, home-secured credit transactions (e.g., HELOCs) from its coverage.
What loans are exempt from imputed interest? ›
Intra-family loans: If the total amount loaned does not exceed $10,000, no imputed interest income needs to be reported by the lender, provided that the loan is not used for income-generating purposes, such as investing in a business that produces income.
What type of lending was made exempt in Dodd Frank legislation? ›
The rule applies to most closed end, consumer credit transactions but excludes home equity lines of credit (HELOC), timeshare loans, reverse mortgages, and short-term bridge and construction loans of 12 months or less.
Does ability to repay apply to construction loans? ›
The ATR Rule and Construction Financing
While the ATR Rule generally applies to any consumer credit transaction secured by a dwelling, when the construction phase of a construction-to-permanent loan is 12 months or less, the construction phase is exempt from Sections 1026.43(c)–(f) of the Rule.
