03/26/2014 01:37 pm ET Updated May 26, 2014

New Mortgage Rules Protect Against Risky Loans

Good news for people shopping for a mortgage -- and for current homeowners facing foreclosure because they can no longer afford their home loan: New mortgage regulations drafted by the Consumer Financial Protection Bureau recently took effect and they provide a slew of new rights and protections for consumers.

One of the cornerstones of the new mortgage rules is that lenders now are required to evaluate whether borrowers can afford to repay a mortgage over the long term -- that is, after the initial teaser rate has expired. Otherwise, the loan won't be considered what's now referred to as a "qualified mortgage."

Qualified mortgages are designed to help protect consumers from the kinds of risky loans that brought the housing market to its knees back in 2008. But obtaining that designation is also important to lenders because it will protect them from lawsuits by borrowers who later prove unable to pay off their loans.

Under the new ability-to-pay rules, lenders now must assess -- and document -- multiple components of the borrower's financial state before offering a mortgage, including the borrower's income, savings and other assets, debt (including alimony, child support and student loans), employment status and credit history, as well as other anticipated mortgage-related costs (home and mortgage insurance, property taxes, etc.)

Qualified mortgages must meet the following guidelines:
  • The term can't be longer than 30 years.
  • Interest-only, negative amortization and balloon-payment loans aren't allowed.
  • Loans over $100,000 can't have upfront points and fees that exceed 3 percent of the total loan amount.
  • If the loan has an adjustable interest rate, the lender must ensure that the borrower qualifies at the fully indexed rate (the highest rate to which it might climb), versus the initial teaser rate.
  • Generally, borrowers must have a total monthly debt-to-income ratio (including regular bills, outstanding debts and potential mortgage payments) of 43 percent or less.
  • The guidelines don't specify a minimum down payment or credit score to qualify.
  • Loans that are eligible to be bought, guaranteed or insured by government agencies like Fannie Mae, Freddie Mac, the Federal Housing Administration and the Veteran's Administration are considered qualified mortgages until at least 2021, even if they don't meet all QM requirements.

Most lenders adopted much tighter lending practices after the financial crisis. The CFPB estimates that over 90 percent of existing mortgages already comply with the guidelines. So-called "no-documentation" and "low-documentation" loans, where borrowers with shaky paperwork used to be approved regardless of whether or not they could actually afford the mortgage, are now forbidden.

Lenders may still issue mortgages that aren't qualified, provided they reasonably believe borrowers can repay -- and have documentation to back up that assessment. For example, many lenders plan to continue making interest-only and jumbo loans or waive the 43 percent debt-to-income ratio for certain customers. However, they'll have fewer legal protections than with qualified mortgages should a buyer later default and decide to sue.

New, tougher regulations also apply to mortgage servicers. (Lenders frequently sell loans to investors after the mortgage has been signed. Those investors, not the consumers, often choose the mortgage servicing company, which is responsible for collecting payments, handling customer service, escrow accounts, collections, loan modifications and foreclosures.)

For example, mortgage servicers now must:
  • Send borrowers clear monthly statements that show how payments are being credited, including a breakdown of payments by principal, interest, fees and escrow.
  • Fix mistakes and respond to borrower inquiries promptly.
  • Credit payments on the date received.
  • Provide early notice to borrowers with adjustable-rate mortgages when their rate is about to change.
  • Contact most borrowers by the time they are 36 days late with their payment.
  • Inform borrowers who fall behind on mortgage payments of all available alternatives to foreclosure (e.g., payment deferment or loan modification).

With limited exceptions, mortgage services now cannot: initiate foreclosures until borrowers are more than 120 days delinquent (allowing time to apply for a loan modification or other alternative); start foreclosure proceedings while also working with a homeowner who has already submitted a complete application for help; or hold a foreclosure sale until all other alternatives have been considered.

A few other features of the new mortgage rules include:
  • Anyone who is paid to offer, arrange or assist in finding you a loan cannot be paid more to steer you into a higher-cost mortgage.
  • If you pay someone directly in connection with a mortgage, he or she generally cannot also receive payment from someone else for the same transaction.
  • Self-employed individuals and others with inconsistent income may have to show additional qualifying information, such as several years' tax returns.
  • The new qualified mortgage rules do allow exceptions for refinancing a consumer out of a risky loan. For example, the ability-to-repay rule may not necessarily apply when a lender refinances a borrower from a riskier mortgage to one that's more stable.
Bottom line: You should never enter into a mortgage (or other loan) you can't understand or afford. But it's nice to know that stronger regulations are now in place to help prevent another housing meltdown.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

To participate in a free, online Financial Literacy and Education Summit on April 2, 2014, go to Practical Money Skills for Life.

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