What Is the Ability to Repay?
The ability to repay refers to an individual’s financial capacity to make good on a debt. In particular, the phrase “ability to repay” was used in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. It describes the requirement that mortgage originators substantiate that potential borrowers can afford the mortgage. This provision of Dodd-Frank is often called the ability-to-repay rule, and “ability to repay” is sometimes abbreviated as ATR.
Under Dodd-Frank, the Consumer Financial Protection Bureau (CFPB) has jurisdiction to create new rules and regulations for the mortgage industry. According to these rules, the loan originators must look at a borrower’s total current income and existing debt. They need to make sure that the existing debt, plus the potential mortgage debt and related expenses, do not exceed a stated percentage of the borrower’s income.
Key Takeaways
- The ability to repay is one’s ability to repay debts and obligations.
- The ability-to-repay rule is the part of the Dodd-Frank Wall Street Reform and Consumer Protection Act that restricts loans to borrowers who are likely to have difficulty repaying them.
- Factors considered in the ability to repay include the borrower’s income, assets, employment status, liabilities, credit history, and the debt-to-income (DTI) ratio.
- As of early 2020, the Consumer Financial Protection Bureau (CFPB) was planning to eliminate the debt-to-income requirements.
History of the Ability-to-Repay Rule
The ability-to-repay rule was included as a response to the mortgage crisis in 2008. Before then, lenders could provide mortgages to homebuyers whose incomes did not demonstrate the ability to pay the monthly mortgage payments. That led to the housing bubble of the 2000s and the mortgage crisis. In the end, a large number of homes faced foreclosure at the same time. Under the new mortgage regulations stipulated by the CFPB, individuals who are not held to the ability-to-repay standard during the origination process may have a defense against foreclosure.
The ability-to-pay rule is a cornerstone of financial stability, according to a paper in The Georgetown Law Journal. Without it, loan-to-value limits are not enough to curb property bubbles. Although loan-to-value limits are important to constraining risk, the denominator—the value—will become artificially elevated during a bubble and will only fall after the bust is under way, shrouding the elevated default risk at origination and giving false confidence that mortgage risk is contained. The mortgage crisis demonstrated that the inability to repay exacerbates default risk, the paper said, along with the resulting further depression in housing prices.
Requirements of Ability to Repay
The CFPB specifies eight factors that determine whether a borrower demonstrates the ability to repay. Based on these standards, the lender makes a reasonable and good-faith decision about the borrower’s ability to repay the loan.
The factors used to determine the ability to repay include the borrower’s current income and assets. They may also include reasonably expected income. The borrower must also provide verification of this income and their employment status.
Besides income, lenders must consider a borrower’s current liabilities. That includes any outstanding debts that they are still paying, as well as child support and other monthly payments. A lender will also check a borrower’s credit history.
Previously, lenders were asked to consider a borrower's debt-to-income (DTI) ratio to make a final determination. But as of December 2020, the DTI requirements of the ability-to-repay rule have been eliminated and replaced with a price-based approach, with the CFPB noting that a loan’s price is a strong indicator of a consumer’s ability to repay.
The move to eliminate DTI requirements came in part because of industry criticism of an existing exemption from DTI rules for loans backed by Fannie Mae and Freddie Mac.
Just because borrowers can get loans under easier rules does not mean that they should. Relatively high home prices in 2020 and the large number of bankruptcies related to the 2008 financial crisis suggest caution.
Exceptions to the Ability-to-Repay Rule
Several types of mortgages are exempt from the ability-to-repay rule. Some of these loans include timeshare plans, home equity lines of credit, bridge loans, a construction phase of less than a year, and reverse mortgages.
Loans backed by government-sponsored enterprises (GSEs), such as Fannie Mae and Freddie Mac, are exempt from debt-to-income requirements. This exemption is called the GSE patch or the qualified mortgage (QM) patch. According to the Independent Community Bankers of America (ICBA), the patch applied to 25% or more of GSE loans as of early 2020. However, the patch will expire on July 1, 2021, or the date when Fannie Mae and Freddie Mac exit conservatorship, whichever happens first. The new rules regarding ability to pay will replace the existing patch.
