Should you be underwriting to residual income?
Are you struggling to implement a residual income policy to mitigate ability-to- repay risks? Maybe you shouldn't. Have you decided not to implement a residual income policy? Maybe you should. It depends!
The Ability-to-Repay regulation (ATR rule) never strictly requires lenders to underwrite to residual income, although it often gives lenders the choice to do so. But could it be helpful/hurtful? What are the pros/cons?
Here's how the ATR rule treats this in different circumstances:
Under the general ability-to-repay rule, lenders must either consider debt-to-income (DTI) or residual income
For Regular QMs, lenders must consider DTI
For GSE-QMs, lenders must consider DTI (as required by Fannie/Freddie, exception for loans guaranteed by VA)
For Small Creditor QMs, lenders must either consider debt-to- income (DTI) or residual income
Who should consider a residual income policy?
Lenders who offer non-QM products
Lenders who originate "rebuttable presumption" QMs (e.g. qualified mortgages that are "higher-priced")
Note: Who should not consider a residual income policy? (i.e. should skip to the end of today's newsletter) (1) "Small creditors"- who essentially will offer only QM products (of one kind or another)- that do not offer higher-priced transactions. (2) Any other lender that has adopted a "QM-only" policy and doesn't offer higher-priced loans.
Pros + Cons of a Residual Income Policy
To reiterate, the ATR rule never requires a lender to use residual income--so the risk is not that of regulatory non-compliance. However, for the lenders in one or both of the categories above, residual income may help reduce the risk of civil liability from the ability-to-repay rule.
PROS
The advantage to residual income is that it can make non-QM lending unattackable (that's definitely an overstatement, it's more like "less easily attackable" But that's still important!).
Example
Bank originates a non-QM loan. $165,000 loan amount, good credit score, 48% DTI. Fast-forward ten years. Loan is in foreclosure, borrower has raised ability-to-repay as a defense.
Bank argument: We had a good faith belief borrower could repay the loan because the DTI, credit score, and other requirement fit within our historically safe underwriting standards.
Borrower argument: Sure, my DTI was relatively low. But you left me with no money for groceries (low residual income)! ... it wasn't "reasonable" for Bank to give me this loan.
In front of a jury, who wins? I think we all know the answer ...
What if (even worse) there is the following information:
Additional information - Borrower is a single mother with two children. Father has never been in the picture. Mother has abnormally high monthly expenses because (i) one child has medical problems, (ii) she has an unusually long commute to work, and (iii) with no family support and long work hours/commute time, she has especially high cost of day- care.
I know what you're thinking - how could we possibly be expected to know any of that? That's exactly the problem. Because what is Borrower going to say? "I told the loan officer that!" Problematically - the bank is responsible for considering this if it "reasonably should have known" -- won't a jury think the bank should have known if it believes Borrower told the loan officer this?
How residual income helps here
In this example, the bank might not have made the loan to the borrower for lack of residual income. Ever heard the saying, "A 'no' to a bad loan is just as valuable as a 'Yes" on a good loan"? So residual income helps that way. Residual income could have also helped if it supported the residual income as reasonable. The bank can counter with, "when we made the loan, the borrower's residual income was well within the limits of historically safe standards -- it was not unreasonable for us to have approved the loan." And that should be a winning argument.
Note:
Underwriting to residual income is crucial if offering higher-priced QMs ("rebuttable presumption" QMs). Here- there is only a presumption (not guarantee) that the lender correctly determined the borrower had the ability to repay the loan. How specifically does the regulation say the borrower may "rebut the presumption" and overcome this barrier? With residual income. It's the only argument here! In this case, considering residual income is a no-brainer. We're more focused here on non-QM lending because higher-priced loans in New England are relatively rare.
CONS
There are some problems with using residual income. Here are just a few we came up with. Do you agree? Do the costs outweigh the benefits for your banks?
Lack of experience with VA standards. How many VA loans has your organization done per year? Do you have historical evidence on the performance of those loans?
Lack of guidance from CFPB on what standards are acceptable for residual income usage. Paraphrasing Nick Hluckyi, Senior Counsel of CFPB at recent webinar, the CFPB's position is that lenders can use VA standards as a starting point, but that the CFPB expects community banks to understand specifically the cost-of-living in their region, and expects national banks to "do some type of regional analysis to determine how much residual income is needed." (Note: this indicates that banks cannot just rely on VA standards!)
General criticism of VA residual income standards. VA standards have been critcised as out-of-date and imprecise. The argument goes- VA only looks at general geographic region, e.g. Northeast, Southwest ... within these broad categories cost-of-living may vary incredibly! **The counterargument is that VA loans have performed relatively well - although do these stats really tell the whole story?
Fair lending. To avoid fair lending concerns, you'll have to follow the policy closely. Otherwise- lending considerations such as marital status, presence of children, and others will start to look bad. And keep in mind a residual income policy is already going to predominantly affect low-income borrowers. After all, there's a lot more residual income with 45% DTI at a $1 million loan amount than there is with 45% DTI at $100,000 loan amount.
Actually using the policy. The tough part about this is you'll probably have to actually deny some loans based of residual income. Really? We're not doing this loan because of where they live and how many kids they have? Again- the pressure to make exceptions just increases risks of fair lending problems.
In other news:
The clock is ticking on commenting on the CFPB's most recent QM proposal. I'm working to submit comments and would appreciate any support from readers--do you think there should be a cure for the 43% limitation? If so, why? Should the CFPB expand on the definition for "small creditors"? What are some anecdotal stories on how doing so would help borrowers?
I can't tell you how much I appreciate the mentorship and support I get here at SCA. Did you know I didn't even know how to tie my shoes before I met John? It's true ... he showed me this video from TED.
What the CFPB taketh, it giveth? The CFPB reports that student loan debt is hurting the real estate market (shocking, we know!)- and the CFPB plans to help by becoming more aggressive with student loan servicers (we sympathize) - will that help us in the mortgage industry?
Do you have a board of directors training library? More and more, we're seeing FDIC and other regulators concerned with training provided to directors. We've seen some institutions develop a "training library" that keeps track of all training given to the board.
In most organizations, there are both "front room" sales/marketing and "back room" people. Too often, probably, the back room people don't get enough credit or attention. We can't forget about the "workhorses" back there ... getting the work done, grinding it out, driving the business. A car might have the best paint job, but it's not worth much without an engine ... a strong engine is going to get you a lot farther than a racing stripe.
A little consideration, a little thought for others, makes all the difference.
- A.A. Milne
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**These are our opinions. We're not authorized, or willing, to express those of others.**