New mortgage rules are mixed blessing for borrowers

New rules designed to establish higher standards for home mortgages are set to go into effect today. While the quality of new loans will improve, resulting in fewer foreclosures, many potential borrowers will be left out in the cold, unable to qualify for a mortgage in the foreseeable future. That group will include the self-employed as well as those with lower incomes and poorer credit histories, and they may become targets for a new wave of predatory lenders.

The new qualified mortgage, or QM, rules adopted by the Consumer Financial Protection Bureau (CFPB) are designed to ensure that banks provide loans only to people who can repay them. One of the chief elements of the Dodd-Frank Act, passed in 2010 to bring greater regulation to the banking industry, the new rules require lenders to verify that borrowers have good credit and will be able to maintain payments. Borrowers must document their income and show that their total monthly debt payments, including that from credit cards and student and auto loans, would not exceed 43 percent of their gross pay each month.

That's a far cry from the precrisis days, when borrowers often had payments of 50 to 60 percent of their monthly income. Mortgage applicants will now be required to submit paperwork detailing their income and must respond in writing to questions about even the most minor anomalies in their credit and financial histories.

Mortgages that adhere to the new guidelines qualify for safe-harbor status, exempting the lending bank from lawsuits aimed at the sort of wayward practices and loose-underwriting standards that lenders adopted during the years leading up to the financial crisis that began in 2008.

Prior to the crisis, which nearly bankrupted the nation, lenders sometimes failed to confirm income and debt while routinely offering adjustable teaser interest rates that would increase after just a few years, raising the mortgage payment to levels borrowers couldn't afford. Many lenders made little or no effort to seek out the facts and often used unsavory methods to approve borrowers, like misrepresenting their incomes and down payments on loan documents.

While banks have since tightened their guidelines in response to the crisis, approving mortgages for only the most creditworthy customers, the QM rules will further alter the mortgage landscape.

"For the first time in the history of mortgage finance, we now have the strongest protections for consumers," said David Stevens, CEO of the Mortgage Bankers Association, a national trade group based in Washington, D.C. "Much of this was overdue, and the reckless endangerment of the previous years is now gone. We've created a safer world for Americans to buy a home." 

The QM rules will draw a clear boundary that lenders cannot cross if they want to avoid lawsuits. But that line will also prevent roughly 20 percent of would-be home buyers from qualifying for a QM loan, according to Stevens. Those borrowers will therefore be forced to consider the nascent world of the non-QM loan.

Before the financial crisis, the self-employed and those with bonus-heavy incomes, such as Wall Street brokers, had a variety of options for obtaining a mortgage, including interest-only or loans requiring little or no documentation. But those types of loans have been eliminated by the regulatory reforms. Higher-income borrowers with pristine credit who don't qualify for QM loans but are searching for loans over $425,000 in most parts of the country ($625,000 in high-income metro areas) can apply for jumbo mortgages. But those come with hefty down -payment requirements, often in excess of 30 percent.

"For decades, interest-only and other types of loans were perfect for a certain clientele — the higher-income self-employed and people that get substantial year-end bonuses," said Frank Pallotta, CEO of Loan Value Group of Rumson, N.J. "Now the real problem for them is the banks won't offer those loans. They don't want to deal with the scrutiny and no safe harbor."

Realizing a potentially profitable segment of borrowers will be left out, lenders have turned to the rating agencies — including S&P, Moody's, Fitch, DBRS and Kroll — to examine the risk of non-QM loans. Kroll, for instance, issued a comment letter on Dec. 5 saying it does not believe that non-QM loans are necessarily high-risk: "On the contrary … non-QM loans may have strong credit attributes, such as borrowers with high credit scores."

Once the rating agencies provide a framework for lenders to write non-QM loans, that segment of the business will likely flourish. But the real concern is for lower-income and poor-credit borrowers. 

Many of those borrowers previously would have qualified for subprime mortgages, which carried high fees and interest rates, often upward of 10 to 15 percent a year. But those loans have been virtually eliminated after billions of dollars' worth of poorly underwritten subprime mortgages blew up during the fiscal crisis. In today’s world, the word "subprime" carries such negative connotations that lenders have deleted it from their dictionaries and instead are lumping poor-credit customers into the non-QM category.

But unlike borrowers with high income and good credit, poorer-credit, lower-earning customers are expected to be targeted by predatory lenders eager to take advantage of the millions of potential borrowers unable to obtain a QM loan. Those who lost jobs during the recession and fell behind on their bills, for example — or, worse, had a home foreclosed on — will find it virtually impossible to be approved for a QM loan.

"This is what I worry about," said Stevens. "The QM rules create a line that is pretty harsh, and for a lot of Americans who fell victim to the worst recession since the Great Depression, they'll find themselves out of the QM box."

Minorities will likely be their chief targets, said Stevens. According to the Federal Reserve, more than 50 percent of African-American applicants were denied mortgages in 2012.

"If they're not qualified for a QM loan, my advice is they should stay out of the market for now," said Stevens.

At least a few firms offering loans to borrowers with poor credit have already sprouted. Citadel Servicing of Aliso Viejo, Calif., has been writing new mortgages since 2012 for borrowers with a foreclosure or even bankruptcy on their records. And those loans are not cheap. They come with higher closing costs and interest rates that exceed 10 percent, as well as down payments exceeding 25 percent.

The CFPB and other regulators will be monitoring the lending landscape once the new QM rules go into effect, with the hope of eventually modifying them to accommodate borrowers who straddle the QM line. But those changes won't come for at least a year, and mortgage brokers point out that some programs remain available for middle- and lower-income borrowers with good to average credit, including ones from the Federal Housing Association and the U.S. Department of Agriculture. A family of four with an annual income under $79,000, for example, can qualify for a USDA loan with no down payment and private mortgage-insurance payments that are much cheaper than those offered by the FHA.

Still, the new QM standard will be the primary model for obtaining a mortgage, and lenders have begun writing loans to QM standards.

"We've been doing this for several months," says Bill Cullen, a Pennsylvania mortgage broker.

Cullen said that in preparation for the new standards, one lender forced a client who works at a local Army base in Tobyhanna, Pa., to obtain additional income verification because his check was cut at a center in Ohio, not Pennsylvania.

"In the old days, we'd just tell the underwriter that he works here but his payroll is centralized. Now I need not only a piece of paper but a third-party verification," said Cullen. "The bottom line is, the customers who couldn't get a loan before QM won't get a loan now, and those on the margins will be shut out."