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.