Why the CFPB’s Qualified Mortgage Rule Misses the Mark

This post grows out of two working papers (downloadable here and here) I’ve written with Joshua Mitts, a former student of mine who is now working at Sullivan & Cromwell.

Why the CFPB’s Qualified Mortgage Rule Misses the Mark
Ian Ayres & Joshua Mitts

Last Friday, the Consumer Financial Protection Bureau’s “qualified mortgage” rule went into effect.  This rule is designed to put an end to the risky lending practices that led to the financial crisis.  But a simpler rule could better assure borrowers’ ability to repay and simultaneously create greater repayment flexibility.

The purpose of the QM rule is to help assure that borrowers have sufficient monthly income to make their required mortgage payments, lessening the risk of large-scale defaults like those experienced after 2008. The rule creates a lender safe harbor for qualifying mortgages.  Lenders can still make non-qualifying loans, but must instead meet more onerous multi-factored underwriting standards. Qualifying loans reduce the risk that lenders will be held liable under Dodd-Frank for failing to make a “reasonable, good faith determination of a consumer’s ability to repay.” 

The CFPB has taken an important first step towards addressing this repayment inability risk by requiring as part of the QM rule that the maximum monthly payment (at any point during the course of repayment) be no more than 43 percent of the borrower’s monthly income (at the time of the initial loan).  But surprisingly, this debt-to-income (DTI) requirement need only be satisfied for the first five years of the loan.  There’s nothing stopping a lender from resetting the interest rate after five years, raising the borrower’s payments to an unsustainable level in light of his or her monthly income.

We think this is a gaping flaw in the QM rules.  The CFPB should mandate that the DTI ratio, calculated based on the maximum required monthly payment, be satisfied for the life of the loan, not merely the first five years.  There’s simply no reason to limit the ability to repay to such a short period.  Under the current QM rules, an interest rate reset five years from now could plunge millions of borrowers into payments they can’t afford.  This isn’t an abstract hypothetical.  Interest rate resets substantially exacerbated foreclosures during the housing crisis.

Insisting on a life-of-the-loan DTI rule could also simplify and soften the QM pre-requisites.  Presently, the QM rule would disqualify any loan that had repayment periods with interest-only or negative amortization.  These prerequisites should be eliminated.  We shouldn’t be concerned about temporary interest-only or negative amortization so long as the DTI requirement is satisfied for the life of the loan.  

To be sure, a fixed-rate mortgage with sufficiently low initial payments would automatically satisfy the life-of-loan DTI standard.  But traditional fixed-rate mortgages shouldn’t be the only kinds of loans to qualify as QMs.  Borrowers and lenders should be given the freedom to agree to any repayment stream that satisfies the life-of-loan DTI requirement.

There’s nothing wrong with giving homeowners the option to skip a payment every once in a while—say, at Christmastime, when the bills are piling up.  Indeed, mortgages that offer payment holidays once a year have been successfully used in New Zealand and other countries for several years.  Giving homeowners this flexibility might actually prevent unnecessary default and foreclosures by easing unexpected liquidity shortages.  “Payment holiday” terms may actually enhance borrowers’ ability to repay their mortgages.

Finally, the QM prerequisites should be better tailored to assure that the borrower’s expected income is sufficient to repay the loan.  Currently, there is nothing to stop lenders from making QM loans to elderly borrowers. But a 63-year-old is unlikely have a sufficient income 30 years later to repay the loan.  This doesn’t mean that elders shouldn’t be able to take out a mortgage to buy a home, but they shouldn’t be able to borrow on a QM basis.  Because QM loans are only appropriate when the borrower’s expected income will be sufficient to repay the loan, QMs should be limited to those loans that are to be repaid within 30 years or when the borrower reaches the age of 65, whichever comes first.  Elders can still choose to refinance their mortgages to cash out the accrued equity in their homes, but both lenders and borrowers should be clear when the repayment is not likely to come from the borrower’s future earnings. 

The QM rule is an important first step towards discouraging the type of improvident lending that sparked the financial crisis.  But as currently constituted it is unnecessarily complicated and poorly tailored toward assuring that borrowers have sufficient earnings to make their payments.

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  1. Voice of Reason says:

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    • Enter your name... says:

      I had a 5-year ARM for about eight years a while back. The interest rate adjusted down at the five-year mark. That’s not unusual. There was both a floor and a ceiling on how low and high the adjustment could be, and a limit on how quickly it could adjust. This, too, is not unusual.

      I knew what I was signing. I knew that I had the ability to deal with the highest possible payment under this mortgage. I knew, too, that I’d be overpaying a bit each month, which meant that the “highest possible payment” in the mortgage paperwork would not be possible after the five-year fixed period expired even if interest rates had skyrocketed. It worked really well for me, and it turned out to be cheaper than the traditional 30-year fixed would have been during those same years.

      Why should *I* be prohibited from getting that product? Your method of protecting “suckers” would have cost me several thousand dollars.

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  2. Walt says:

    Mortgages that adjust to maximal interest after 5 years can be useful products. In this case, underwriting must evaluate the borrower’s likely ability to refinance (the typical use of the product). Need safeguards to make sure naive borrowers don’t think it’s a conventional 30 year. If a prospectus for a derivative security assumed that anyone would actually be paying the maximal interest, that should lead to a fraud case.

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  3. Dustin says:

    It is an interesting proposal. I need to read the WP’s. I’m curious what adjustment rule would work to permit ARM’s Particularly in the admittedly unlikely case of high interest rates. If they had risen significantly, it is likely due to high inflation and without adjustment the lender is now being repaid at a real rate below what they anticipated. Keying the new rates to original income would probably not make sense. In all likelihood given the high inflation, the borrowers wage is now much higher in nominal amounts so may be a reasonable reference. However reference relative to it would penalize who worked hard to get a higher salary, while penalizing lenders to those who may not have worked as hard thus had relatively small salary gains. A possible resolution would be to use use inflation, in the rule.

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  4. Steve says:

    This is a surprisingly poorly thought out article. Not allowing a QM to a 63 year old? The author apparently hasn’t heard about Fair Lending and Equal Credit Opportunity Act Laws. The difficulty with underwriting us that the decision to approve/deny is based on a single point in time. The reason five years makes sense is that most peoples financial situations change entirely every five years. People get promotion, have children, retire, etc. predicting someone loss term financial future by its nature would lead to unfair banking practices based on what would be well-intentioned but likely flawed assumptions. In fact, the average 30-year fixed rate loan only lasts about 7 years because people sell their house or refinance.

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    • Enter your name... says:

      Then maybe seven years would make more sense. Or maybe it should be not when the median mortgage is changed, because that would still leave 50% of mortgages affected, but for however long two-thirds or three-quarters of them last.

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  5. Enter your name... says:

    I don’t like the idea of using age 65 as the benchmark, especially since the full Social Security retirement age right now is 66 (anyone who qualified for retirement at age 65 is already older than that). Age 67 or 70 would make more sense.

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  6. James says:

    Why the assumption that someone taking out a 30-year mortgage at 63 would not have sufficient income 30 years later? It should, after all, be quite simple to compute anyone’s expected minimum income at that age: add up expected Social Security paymentts plus RMDs on 401k & IRAs.

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    • Enter your name... says:

      Well, for starters, most of us are dead when we’re 93.

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      • James says:

        And how is this a problem, exactly? (For the lender, of course – if the borrower has problems, they’re out of our reach.) The property & mortgage are part of the estate, and either pass to the heirs, or the property is sold to settle the estate. Same as if I borrow at 30, and die at 35.

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  7. NotAnotherSkippy says:

    I’m confused or this is poorly worded or both.

    “requiring as part of the QM rule that the maximum monthly payment (at any point during the course of repayment) be no more than 43 percent of the borrower’s monthly income (at the time of the initial loan).”

    How is “at any point during the course of repayment” consistent with “this debt-to-income (DTI) requirement need only be satisfied for the first five years of the loan?”

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  8. Blaine says:

    How would you even propose to calculate what someones income is over a 30 year span?!

    “Borrowers and lenders should be given the freedom to agree to any repayment stream…”

    They currently do that right now. No one has ever had a gun pointed to thier head and forced into an adjustable rate mortgage. All you’re proposing is an additional incalculatable factor.

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