Can you limit Ability-to-Repay risk by considering residual income, even though that's not a man
Under the new mortgage regulations, residential mortgage lenders are barred from making a loan without first making a determination that the consumer has the ability to repay the loan. In making this determination, lenders are permitted to consider either the consumer's debt-to-income ratio or the consumer's residual income. 12 CFR 1026.43(c)(2)(vii). So, technically, you can ignore residual income, but is that the smartest strategy?
We here at Spillane Consulting Associates would like to share our opinion that considering residual income--whether technically necessary or not--is the best practice. First, we believe it is an important way to mitigate risk created by the ATR/QM rules. Second, it is relatively easy. This may be a case of where your institution shouldn't ask, "What can we do?" but instead, "What should we do?"
Why is considering residual income an important way to mitigate risk created by ATR/QM?
First, it will be important in defending against general ability-to-repay claims. There might be a 20% DTI, but the borrower in foreclosure is still going to argue, "yeah, but you only left me $20/month to live on! You should have known I did not have the ability to repay the loan!" Fight back against this with documented proof of the borrower's residual income, e.g., "Well, according to this signed document in the loan file, we qualified you for this mortgage in part because you promised that your residual income was $1,000/month. Just because your circumstances have since changed, that does not affect whether we had a good-faith belief that you could repay the loan at the time."
Second, if you were wondering how borrowers will rebut the (rebuttable) presumption of compliance for higher-priced qualified mortgages, this is how -- borrowers will argue they were left with little or no residual income.
Third, this is also important (in a round-a-bout way) for "safe harbor" QMs. As you know, the borrower can always challenge the loan's status as "qualified" or not. If a mistake is made (think points and fees or DTI), and the loan is actually not a QM, then residual income will be important for the same reason as in regular ability-to-repay cases.
Remember this is residual income based on what you know (or reasonably should know) at the time of consummation. The borrower is always going to claim he later suffered setbacks that reduced his residual income to where he had no ability to repay... but the beauty of this is that your good-faith ability-to-repay determination is made based on information known or reasonably available to you at the time of consummation.
How do we properly consider residual income for ATR/QM purposes?
There is no mandatory residual income criteria, as with VA loans. Just subtract "total monthly debt obligations" from the consumer's "total monthly income." Do you prefer making this decision (how much is enough residual income) or would you have preferred something similar to the "VA option?"
There is also no verification requirement for residual income ... you can take the consumer at his or her word! We recommend asking consumers directly about their residual income. Document the question and answer, and keep this in the loan file. Of course, your acceptance and consideration of this must be "reasonable"... don't rely on the borrower's statement if you have information that contradicts the borrower's claimed residual income.
Also, be sure to actually use this in determining ability-to-repay. For example, "based on the borrower's residual income, [your institution] believes that the borrower has the ability to repay this loan." Don't waste your time gathering and documenting this information by not actually considering this in making the ability-to-repay determination. This won't always be a "freebie" ... there may be cases where your institution will decline loans based on a lack of residual income. You should likely have a policy to determine at what level residual income will disqualify a borrower (why? because these denials will pose a particular fair lending risk). And for the majority of loans where residual income only supports your decision to make a loan, why not document this and help limit the risks created by the new mortgage regulations?
Counterargument
We recognize there's an argument that residual income should not be considered for regular qualified mortgages, i.e. you should only consider residual income when originating non-QMs or higher-priced QM (rebuttable presumption). Why should you go above and beyond to consider residual income when you're already protected from ATR liability by the QM status and the only effect of considering residual income for QMs will be to deny more loans. The consumer has already jumped through so many hoops to qualify for a QM, why should we gratuitously punish ourselves by adding another? That's a decision for your institution to make--and we leave that to your discretion when we provide consulting services. But we'll leave you with this question .... forget about QM and the CFPB... do you want a loan with 20% DTI in your portfolio if the borrower has nothing left over for living expenses? How do you think investors will answer that question? It's unlikely considering residual income will cause many denials-- is that worth being able to tell investors with confidence that, "we only originate quality loans"?
Finally, there are probably a number of ways to abuse this. Many of you may be amused to think we recommend trusting the borrower in determining ability-to-repay. Please remember you must only do so if "reasonable"--"over- reliance" on unverified residual income might be unreasonable... make sure the borrower understands this is important information and that your institution is relying on it. You can trust the borrower... but abusing this will only defeat the purpose of considering residual income at all.
You don't have to consider residual income, but if you don't consider it you're going to lose a lawsuit. Not requiring consideration of residual income (but including that as an option in the rule anyway) may be an example of the regulators giving institutions just enough rope to hang themselves. "Where there is no vision people perish." Solomon, King of Israel (970- 928 BC). So use your vision! In comparison to other problems created by the new mortgage regulations, this should be a relatively simple fix!
Happy Thanksgiving! It's not easy to relax when others depend on you. At least some people will say that a healthy amount of relaxation increases productivity... whether you believe that or not, you should never feel guilty about making time for family.
Thanks so much for reading our weekly newsletters. We're not always going to be perfect, but because we always do our best and try not to overpromise, we hope that we're always going to be trustworthy. Your calls and e-mails are very helpful - please keep contributing.
**These are our opinions. We're not authorized, or willing, to express those of others.**