Introduction to mortgage section of Dodd-Frank Act
New financial reform legislation includes provisions to prevent lenders from offering mortgages borrowers can’t afford or understand.
The Dodd-Frank Wall Street Reform and Consumer Protection Act devotes more than 200 pages to a section called the Mortgage Reform and Anti-Predatory Lending Act. It addresses issues as diverse as prepayment penalties and Chinese drywall.
The legislation says its purpose is “to assure that consumers are offered and receive residential mortgage loans on terms that reasonably reflect their ability to repay the loans and that are understandable and not unfair, deceptive or abusive.”
The following slides explain how the new legislation may affect your next mortgage.
The mortgage reform legislation sets minimum standards for lenders. The most basic new standard prevents a creditor from offering a residential mortgage to a borrower without “a reasonable and good faith determination … that … the consumer has a reasonable ability to repay the loan.”
Ability to repay is a straightforward calculation for fixed-rate loans. For adjustable-rate mortgages, the lender must ignore the introductory (or “teaser”) mortgage rate when determining whether a borrower can afford the loan.
Instead, the lender has to calculate what the payments would be if the borrower got a fixed-rate loan at the ARM’s fully indexed rate.
Take the example of a borrower getting a 5/1 ARM with a fully indexed rate of 2.25 percent above the one-year Libor. At closing, the one-year Libor rate is 3 percent. Add them together for a fully indexed rate of 5.25 percent.
The lender will determine whether the borrower can afford the payments on a 30-year, fixed-rate mortgage at 5.25 percent — even though the borrower initially will pay less, and eventually might pay more (if rates rise later).
The legislation says the lender has to verify income, preferably with tax transcripts obtained from the Internal Revenue Service.
Favorable treatment for ‘qualified mortgages’
The legislation gives favorable treatment to plain-vanilla “qualified mortgages.” Lenders can sell qualified mortgages to investors with fewer strings attached. That gives lenders an incentive to give consumers mortgages without tricks and traps.
Has taxes, insurance and assessments included in the monthly payments.
Meets debt-to-income standards.
Can’t be longer than 30 years.
Has reasonable points and fees.
The legislation says points and fees generally shouldn’t exceed 3 percent of the loan amount. There are exceptions for smaller mortgages.
The lender also has to verify and document the borrower’s income and savings, and there are limits on prepayment penalties on qualified mortgages. If a lender offers a loan with a prepayment penalty, the lender also has to offer a similar loan without a prepayment penalty.
The legislation imposes restrictions on loans that don’t meet the definition of “qualified mortgages.”
Prepayment penalties are banned on nonqualified mortgages. This ban will make it easier for homeowners to refinance out of tricky mortgages. It probably also will make such mortgages less profitable to lenders.
Essentially, if a loan offers the possibility of negative amortization, the lender must tell the borrower that getting the loan is a bad idea. A first-time borrower won’t be able to get an option ARM without first getting housing counseling from a HUD-certified agency.
During the housing boom, lenders eagerly underwrote subprime, interest-only, option ARM and stated-income mortgages. After the housing boom, those types of loans disappeared or became scarce. The legislation is designed to ensure they will remain no more than niche products.
During the Wild West days of the housing boom, lenders were known to give subprime mortgages to people with good credit who could have qualified for low-rate prime loans. The practice — called “steering” — now is illegal.
In a related abuse, mortgage originators sometimes lied to borrowers about their credit, telling borrowers they had low credit scores when they really didn’t. That practice now is illegal.
The legislation bans abusive lending practices on the basis of race, ethnicity, gender or age. This rule targets “affinity fraud,” in which a loan officer of a given ethnicity fleeces borrowers of the same ethnicity by taking advantage of their trust.
It’s illegal to lie about the appraised value of the property being mortgaged.
Under some circumstances, the legislation mandates lenders say or do certain things. One of these requirements concerns deficiency judgments.
In some states, the lender can sue a borrower after foreclosure to recover the difference between what the borrower owed and the price for which the bank sold the house. The outcome of this lawsuit is called a deficiency judgment, and a state that allows deficiency judgments is called a recourse state.
At least three states — California, Montana and North Carolina — are a mix of recourse and nonrecourse. In these states, the lender can’t seek a deficiency judgment on the loan the borrower got to buy the house. But if the borrower refinanced the original loan, the lender can seek a deficiency judgment.
The act requires lenders in those states to warn borrowers applying to refi that they will give up protection against deficiency judgments if they refinance.
Another section of the legislation requires mortgage servicers to warn ARM borrowers about rate resets. Six months before the ARM rate resets for the first time, the lender must deliver an estimate of how much the monthly payment will be.
The Dodd-Frank legislation prevents mortgage brokers from pocketing income from the lender and the borrower on the same loan. This rule protects consumers from abuses, but at the expense of restricting flexibility to choose creative loan terms.
Mortgage brokers are well-known for providing no-points, no-fee mortgages in which the borrower pays few or no closing costs. There’s no such thing as a free lunch, so in exchange for paying little or nothing out of pocket, the borrower pays a higher interest rate.
Behind the scenes, it works like this: The lender pays the broker a commission for delivering a mortgage at a higher-than-par interest rate. This commission is called a yield spread premium, or YSP. Out of the YSP money, the broker pays all third-party transaction fees (for the title report, for example) and takes a cut for himself or herself. In some cases, the broker rebates some money to the borrower.
The legislation forbids brokers from collecting yield spread premiums while also charging borrowers discount points, origination points or origination fees.
This means you can’t get a no-fee loan from a broker while at the same time paying discount points to bring down the higher rate.
When you apply for a mortgage modification, the lender applies a “net present value test” to decide whether to grant the modification. The NPV test makes some guesses about the likelihood that you’ll default, how much the home is worth now and how much it will be worth a year from now, how much it would cost to foreclose, and what price the house would sell for after a foreclosure.
Most of the numbers in the NPV test are secret: The lender doesn’t have to disclose the odds that you would redefault, for example.
The Dodd-Frank legislation requires lenders to disclose the assumptions used in the NPV test whenever they reject an application for a mortgage modification. But it doesn’t provide a way to appeal modification rejections.
Regarding the government-sponsored enterprises, or GSEs, the legislation says the “hybrid public-private status of Fannie Mae and Freddie Mac is untenable” and says something should be done. But it doesn’t say what.
Finally, the legislation orders the feds to “conduct a study of the effect on residential mortgage loan foreclosures of … drywall that was imported from China” from 2004 to 2007.