On July 14, 2008, the Federal Reserve Board (the “Board”) unanimously approved a final rule that offers broader protections for borrowers of “high priced mortgages.” This rule will apply to all mortgage lenders—not just those under the supervision of the Board. Adopted under the Home Ownership and Equity Protection Act, the new rule amends Regulation Z of the Truth in Lending Act. All but one of the new requirements will take effect on October 1, 2009.

Protections for “higher-priced mortgage loans”

The new rule (the “Rule”) creates four protections for “higher-priced mortgage loans” (a new category created by the rule) that are secured by a borrower’s principal dwelling. This new category of loans is defined as:

  • a first lien mortgage loan with an annual interest rate of 1.5 percentage points above a new index to be published by the Board

or

  • a subordinate lien mortgage with an annual interest rate of 3.5 percentage points above the Board’s new index.

The “higher-priced mortgage loan” category will encompass virtually all subprime loans, but generally exclude prime loans.

For loans that fall within the definition of this new category, the four protections included in the Rule will:

  1. Prohibit lenders from making a loan without considering the borrower’s ability to repay from any income or assets other than the value of the home. In making this determination, the lender complies, in part, by reviewing the highest scheduled payments in the first seven years of the loan. To create liability on the part of a lender, a borrower does not need to establish a “pattern or practice” by the lender; instead, the borrower need only show that his or her ability to repay the loan was not properly considered.
  2. Require lenders to identify the borrower’s income and assets to be relied upon in determining whether the borrower can repay the loan. To satisfy this requirement, the Rule suggests that lenders review the borrower’s Internal Revenue Service Form W-2, tax returns, payroll receipts, bank records and/or other similar documents.
  3. Prohibit the imposition of any prepayment penalties if the amount of the monthly loan payment can change in the first four years of the loan (for example, in the case of adjustable-rate loans); if the loan does not adjust, the Rule restricts a prepayment penalty from lasting longer than two years.
  4. Require lenders to establish escrow accounts to pay the borrower’s property taxes and homeowner’s insurance for all first lien mortgage loans. The lender can offer the borrower the opportunity to cancel this escrow account after one year. [This requirement will not be enforced as of October 1, 2009. It will be phased in during 2010 to permit lenders to adopt new internal systems to meet this requirement.]

Protections for all loans secured by a borrower’s principal dwelling

Regardless of whether a loan meets the definition of a “higher-priced mortgage loan,” the Rule also creates the following protections for borrowers:

  1. Lenders and mortgage brokers are prohibited from compelling a real estate appraiser to misstate the value of a home.
  2. Mortgage loan servicers cannot “pyramid” late fees; they must credit loan payments on the dates they are received and provide a payoff statement within a reasonable time after it is requested.
  3. Within three days after a borrower applies for a loan that will be secured by his or her principal dwelling, lenders must provide Good Faith Estimates of the costs associated with the loan, including a schedule of payments. (Previously this requirement applied only to home-purchase loans; the Rule extends this protection to home-improvement and refinance loans.) A borrower cannot be charged any fee until these disclosures are received, except for a reasonable fee for obtaining the borrower’s credit report.

What this means to you

The stated goal of the Board in adopting the Rule was “to protect borrowers from practices that are unfair or deceptive and to preserve the availability of credit from responsible mortgage lenders.”[1] Clearly, the Rule is intended to address the public outcry and concerns over the state of the mortgage industry. The focus of the Rule is properly on those less-than-respectable mortgage lenders who took advantage of loopholes in the applicable statutes and regulations to do an end-run around responsible lending.

The Rule’s primary intent is to protect potential borrowers by (a) making them better informed, (b) providing them with the tools to help find the best loan product for their needs, and (c) ensuring the benefits of early disclosures and unbiased appraisals. Lenders, too, should benefit as borrowers will find it more difficult to claim that they did not understand the terms of their loans.