Dodd-Frank Act Requirements Force Mortgage Lenders to Get Creative
The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) in January, 2014, forced lenders to creatively circumvent the rigid restrictions placed on the traditional loan approval process. The primary goal of the Dodd-Frank Act was to stabilize the housing market by preventing the approval of risky mortgages. To do so, the Dodd-Frank Act classifies mortgages as qualified or non-qualified based on a set of strict financial standards. For example, a borrower’s total debt payments post-mortgage must not exceed 43 percent of their pre-tax total income to be considered a qualified mortgage.
Lenders are still allowed to write non-qualified mortgages; however, if the loan is determined to have been inappropriately issued and the borrower defaults on their payments, the lender could face fines and legal action imposed by the Consumer Financial Protection Bureau (CFPB). This puts lenders in a tough position. If they only write qualified mortgages, they’ll severely restrict their market. Conversely, writing non-qualified mortgages can be a legal risk. Fortunately, there are strategies lenders can implement to continue writing non-qualified mortgages while reducing risk.
Using residual income to gauge the ability to repay
A residual income test looks at how much money an applicant will have at the end of the month after they make their loan payments. The Department of Veteran Affairs uses this test for VA loans and credits this test for low delinquency rates.
For example, let’s say you have a borrower who will be putting 50 percent of their income towards loans after they take out a mortgage, thereby making the mortgage non-qualified. If that applicant is making $200,000 a year, chances are they’ll still have enough money left over after their loan payments and are worth considering for a mortgage. However, if an applicant is only making $40,000, then operating under those terms would be much riskier.
Looking beyond income
The Dodd-Frank Act requirements address income as the primary gauge of an applicant’s qualifications. As a result, some low-income applicants that actually have the capacity to safely handle a mortgage could be overlooked. A retiree, for example, may appear at first glance to be non-qualified due to a low annual income. After closer inspection, you may discover a large savings account that can make up for the difference and ensure timely payments.
Looking beyond income and savings, deductibles are also a factor to consider, especially in the case of self-employed individuals. These workers have above-average tax deductions and may be deducting major expenses like their car payments, health insurance premiums, and part of their mortgage payments. A self-employed worker with $50,000 in income might have the spending power of an employee making $70,000 a year. When it comes to self-employed workers, you should look beyond their reported income and into their actual cash flow. Examining their tax returns, especially their Schedule C, can grant you such insight.
Treating every non-qualified mortgage applicant separately
Whenever you’re considering non-qualified mortgages, treat them on a case-by-case basis the cost of overlooking something is too great. This extra initial investment in time can avoid problems when a borrower’s first payment is due.
While the Dodd-Frank Act has made lending to non-qualified applicants a bit more complicated, these strategies can help expand your loan portfolio while staying compliant with new mortgage requirements.