Federal regulators have finalized new guidance on subprime lending, instructing banks and other lenders to qualify borrowers at the fully indexed rate, and not allow stated income and reduced documentation unless mitigating factors “clearly minimize the need for verification of a borrower’s repayment capacity.”

The guidance on subprime lending, which applies to many adjustable-rate mortgages, also includes consumer protections including more thorough disclosure of loan terms and limits on prepayment penalties for borrow

Federal regulators have finalized new guidance on subprime lending, instructing banks and other lenders to qualify borrowers at the fully indexed rate, and not allow stated income and reduced documentation unless mitigating factors “clearly minimize the need for verification of a borrower’s repayment capacity.”

The guidance on subprime lending, which applies to many adjustable-rate mortgages, also includes consumer protections including more thorough disclosure of loan terms and limits on prepayment penalties for borrowers seeking to refinance to avoid an interest rate reset.

By instructing banks to qualify borrowers at the fully-indexed rate — evaluating their ability to make monthly payments after an introductory interest rate expires — the guidance is likely to reduce the number of people who are eligible for such loans.

The Mortgage Bankers Association, which has opposed new restrictions on lenders, called the guidance “a strong statement that will help curb abuses, but will likely also constrain consumer credit choices.”

The MBA supports legislation to modernize the Federal Housing Administration to make its mortgage guarantee programs available to more people, but urged Congress to “refrain from passing legislation that will further constrain credit by forcing lenders to deal with rigid underwriting standards and litigation risk.”

Some consumer groups have argued that the guidance doesn’t go far enough in restricting the use of loans with low introductory payments and penalties for refinancing. The Center for Responsible Lending, for example, supports proposed legislation authored by Sen. Charles Schumer, D-N.Y., the Borrower’s Protection Act. That legislation, in addition to requiring originators to underwrite loans at the fully indexed rate, would establish a fiduciary duty for mortgage brokers and originators and create a “faith and fair dealing” standard for lenders.

Like guidance issued last fall for nontraditional or “exotic” interest-only and pay-option loans, the new standards for ARM loans only apply to banks, savings and loans, credit unions and other lenders regulated at the federal level. Mortgage brokers, banks and non-bank lenders regulated at the state level aren’t affected unless states decide to adopt their own versions of the guidance.

The Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) endorsed the subprime guidelines when they were first proposed, and are expected to campaign for states to adopt them. So far, more than 30 states have adopted the federal guidance for nontraditional loans.  

Subprime ARM loans, which typically offer two or three years of lower introductory interest rates, have been blamed for the recent rise in delinquencies and foreclosures. Although touted as a way for entry-level home buyers to buy into rapidly appreciating markets, a slowdown or reversal of home price appreciation has left many ARM borrowers unable to refinance such loans before their interest rates reset.

“These products originally were extended to customers primarily as a temporary credit accommodation in anticipation of early sale of the property or in expectation of future earnings growth,” regulators said in the new guidance. “However, these loans have more recently been offered to subprime borrowers as ‘credit repair’ or ‘affordability’ products.’ “

Subprime borrowers who qualify for a loan based on a low introductory rate may experience “payment shock” when their interest rate resets, the guidance notes. The monthly payment on a $200,000 2/28 loan, for example, jumps from $1,331 per month at 7 percent interest to $1,956 a month at the fully indexed rate of 11.5 percent. Add taxes and insurance, and a borrower earning $42,000 a year suddenly has a 62 percent debt-to-income ratio, as opposed to 44 percent at the lower introductory rate.

The problem is compounded by the fact that many loans carry hefty prepayment penalties for refinancing a loan to avoid the interest rate reset. The guidance says the lenders should allow borrowers “a reasonable period of time” to refinance their loans without penalty — typically, at least 60 days before the reset date.

The guidance also stipulates that prepayment penalties should not extend past the initial reset period, although there is no expectation that lenders will waive prepayment penalties on existing loans.

The guidance applies to ARM loans with one or more of the following features:

–Low initial payments based on a fixed introductory rate that expires after a short period and then adjusts to a variable index rate plus a margin for the remaining term of the loan.

–Very high or no limits on how much the payment amount or the interest rate may increase (“payment or rate caps”) on reset dates.

–Limited or no documentation of borrowers’ income.

–Product features likely to result in frequent refinancing to maintain an affordable monthly payment.

–Substantial prepayment penalties and/or prepayment penalties that extend beyond the initial fixed interest rate period.

“Products with one or more of these features present substantial risks to both consumers and lenders,” regulators said. “These risks are increased if borrowers are not adequately informed of the product features and risks, including their responsibility for paying real estate taxes and insurance, which may be separate from their monthly mortgage payments.”

Although the guidance applies to subprime borrowers, regulators advise that lenders “generally should look to the principles of this statement when such ARM products are offered to non-subprime borrowers.”

The guidance was issued jointly by the Office of the Comptroller of the Currency, the Federal Reserve, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the National Credit Union Administration.

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