On Wednesday, May 11, the Federal Reserve Board (the “Board”) issued proposed changes to its Regulation Z (Truth in Lending) in order to implement changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”).

The Board’s proposed rule would amend Regulation Z in the following four main areas:

Expansion of the “Ability-to-Pay” Rule.

Currently, Regulation Z requires certain underwriting standards for “high-cost mortgages,” as required by the Home Ownership and Equity Protection Act (HOEPA). Among these requirements is a determination by the lender of the borrower’s ability to repay the loan. The Board’s proposed rule would apply a similar, though not identical, ability-to-pay standard to any consumer credit transaction secured by a dwelling, except for open-end credit plans, timeshares, reverse mortgages and temporary loans (those with a term of 12 months or less). The final rule would prohibit a lender from making such a loan unless it makes a reasonable and good faith determination, based upon appropriate documentation, that the borrower will have a reasonable ability to repay the loan (including related costs, such as escrowed payments). An example of the expanded reach of the ability-to-pay rule would be a closed-end home improvement loan on a vacation residence. Currently, HOEPA does not require this analysis by lenders making such loans. The final rule would impose such a requirement.

Standards for Compliance with the “Ability-to-Pay” Rule.

The final rule would provide four options for lenders to comply with the new ability-to-pay rule:

  1. By originating a mortgage loan for which:
    1. The lender considers, and verifies, all of the following factors:
      • Current or reasonably expected income or assets;
      • Current employment status;
      • The amount of the monthly payment on the mortgage loan;
      • The monthly payment on any “simultaneous loan” (a loan secured by the same dwelling and made at the time of or before the mortgage loan);
      • The monthly payment for any mortgage-related obligations;
      • Current debt;
      • The monthly debt-to-income ratio; and
      • Credit history; and
    2. The mortgage payment calculation is based upon the fully indexed rate (or the initial rate, if higher).
  2. By refinancing a “non-standard mortgage” into a “standard mortgage.” A “standard mortgage” would be defined as one that, among other things, does not have negative amortization, interest-only payments, or balloon payments, and has limited points and fees. This option is available if (i) the lender is refinancing its own loan, (ii) the payment under the “standard” mortgage” is lower than the payment under the “non-standard mortgage” and (iii) the “non-standard mortgage” has not been delinquent for non-payment.
  3. By originating a “qualified mortgage.” Due to an ambiguity in the Act, the Board is proposing two alternative definitions of “qualified mortgage,” one operating as a safe harbor, the other operating as a rebuttable presumption of compliance:
    1. Safe Harbor Alternative. A “qualified mortgage” is one for which:
      • There are no negative amortization requirements, interest-only payments, or balloon payments;
      • The loan term does not exceed 30 years;
      • The total points and fees do not exceed 3% of the total loan amount (and the proposed rule contains two alternatives for implementing the limits on points and fees, and contains a definition of “points and fees”);
      • The borrower’s income or assets are verified and documented; and
      • The lender’s underwriting assumes the maximum interest rate in the first five years of the loan, uses a payment schedule whereby the loan is fully amortizing over the term, and takes into account all mortgage-related obligations (such as escrows).
    2. Rebuttable Presumption Alternative. This alternative adopts the above requirements and adds the following ones:
      • The borrower’s employment status;
      • The monthly payment for any “simultaneous loan” known to the lender;
      • the borrower’s debt;
      • The total debt-to-income ratio or residual income; and
      • The borrower’s credit history.
  4. In certain circumstances, by originating a balloon-payment qualified mortgage that meets the criteria set forth in the Act. This option is available only to small lenders operating in rural or underserved areas that make fewer than a specified number of these loans (or, in the alternative, less than a specified dollar amount of these loans). Such loans would need to remain in the lender’s portfolio (but the Board is soliciting comment on alternative ways of implementing this requirement). Such a lender may originate a balloon-payment qualified mortgage if the loan term is five years or more and the payment calculation is based upon the scheduled periodic payments, excluding the balloon payment. These loans would be subject to the same points and fees, and underwriting, requirements as other “qualified mortgages.”

Limits on Prepayment Penalties.

A transaction covered by the new rule may not contain a prepayment penalty unless the transaction:

  • Has an APR (annual percentage rate) that cannot increase after consummation (i.e., a fixed rate or step-rate mortgage);
  • Is a “qualified mortgage” (see paragraph 2(c), above); and
  • Is not a “higher-priced mortgage loan.”

If a prepayment penalty is permitted, it cannot exceed 3% of the outstanding loan balance during the first year of the term of the loan, 2% during the second year and 1% during the third year. No prepayment penalty is permitted after the third year of the term of the loan.

If a lender imposes a prepayment penalty on a loan offered to a borrower, it must also offer a loan to the borrower that does not contain a prepayment penalty.

Record Retention.

Lenders are required to maintain evidence of compliance with these requirements, as well as the rest of Regulation Z, for three years after consummation of the loan. The statute of limitations for civil liability for violations of the prepayment penalty and the ability-to-pay requirements (including the qualified mortgage provisions) is extended to three years after violation.

The proposed rule is 117 pages long in the Federal Register, and contains many specific requests for comments on alternatives (some of which are mentioned above), thresholds and other requirements. Lenders may comment, and should do so if they think that these changes, or the specifics of the implementation of these changes as published in the notice, will have an adverse effect on their businesses. According to the notice of proposed rulemaking, comment letters should refer to Docket No. R-1417 and RIN No. 7100-AD75 and may be mailed electronically to regs.comments@federalreserve.com. The comment period ends July 22, 2011. Since general rulemaking authority for the Truth In Lending Act will be transferred to the new Consumer Financial Protection Bureau in July of 2011, the final rule will be issued by that agency and not by the Board.