What Does a ‘Qualified Mortgage’ Mean?

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cirellimugThe Consumer Financial Protection Bureau recently released the definition of a “qualified mortgage”. This definition is intended to shape the future of mortgage lending and prevent a recurrence of the financial meltdown that occurred a few years ago.

The intent is to provide a “safe harbor” or exemption from litigation and penalties to lenders making loans that meet the definition of the government’s “qualified mortgage”.  The rule applies to mortgages that are made with the intention of sale to the governmental agencies known as Fannie Mae, Freddie Mac and FHA. These loans account for more than 90% of all loans originated in the U.S. Jumbo loans are not included, but it is expected that jumbo lenders will follow suit.

The ruling has been anticipated for about 18 months and the mortgage industry has been somewhat surprised that it did not contain more restrictions. For example, the ruling stopped short of requiring a minimum down payment of 20% and other features that the industry feared.

The ruling is centered on the borrower’s ability to repay the loan. In general, the qualifying criteria are as follows:

That the consumer have a total debt-to-income ratio that is less than or equal to 43%.

That monthly payments be calculated based on the highest payment that will apply in the first five years of the loan.

The loan must not contain certain “undesirable” terms or features such as.

No-doc or stated-income loans where the income or assets are not verified.

Interest-only payment loans.

Loans with other “risky” characteristics such as teaser rates, negative amortization, balloon payments, and terms exceeding 30 years.

What does it mean?

First of all, loans with risky characteristics all but disappeared in the early days of the mortgage meltdown a few years ago. There are still some interest-only loans that are available but the rest of the programs have already been eliminated from mainstream lending sources.

The most important aspect of the rule is the 43% debt-to-income (DTI) ratio limitation. The DTI has always been the primary criteria for qualification. A limit of 43% is reasonable and, the ruling states that higher ratios are allowed if the loan has been pre-approved by the Fannie Mae, Freddie Mac or FHA automated underwriting programs. Presently, these programs allow DTI ratios as high as 45% to 50%, depending on a borrower’s strength.

The debt-to-income ratio is calculated first by calculating the borrower’s monthly principal, interest, taxes and insurance payments on their home plus mortgage insurance and homeowner association dues to determine their total primary housing expense payment. Then their other monthly debts such as car payments, student loans and the minimum required credit card payments are added to the housing expense to determine the total monthly obligations. That total is then divided by the borrowers monthly income. the result is the debt-to-income ratio.

It’s too soon to tell, but despite being more liberal than the industry anticipated, I interpret the rule to be a little more restrictive for certain homeowners and buyers. The rule doesn’t actually go into effect until next January, so there is still plenty of time for changes to the program and for lenders to phase in implementation.

The new rule could mean higher rates and more difficult qualifying criteria for loans outside of the box – primarily jumbo loans that already have stricter qualifying criteria. Some first-time homebuyers and self-employed borrowers may be eliminated too as these buyers often have higher debt to income ratios.

On the other hand, some experts argue that now that the industry has a clear definition, lenders can eliminate some of the unnecessary restrictions that they presently impose. The intent of the definition was to help loosen credit standards. And with protection from liability for loans that do meet the definition, qualified mortgages should be easier to obtain.

Still to come is the government’s ruling on qualified residential mortgages, which may require lenders making loans outside of the definition to maintain cash reserves as a percentage of the loan amount. The theory is that if the lenders have “skin in the game” they are unlikely to make risky loans that could end up in default.

The important thing for any reader here is that there are many factors well beyond anyone’s control that can and do move the financial markets and interest rates with extreme speed. In the meantime, rates are still extremely low and it’s a good time to buy or refinance.