The Dodd-Frank act requires that originators make a good faith effort to verify a borrower’s ability to repay their mortgage and imposes stiff penalties if they do not (ATR and QM rules). This makes sense for the safety of the borrower and the market. Some originators have expressed concern, though, pointing to a need for more clear rules that define a borrower’s ability to repay. For example, a borrower may have outsized obligations that are not reflected in a debt-to-income ratio.
One suggestion is a residual income test, which has been used successfully by the VA for years. A residual income test measures how much after-tax income remains after all debt (e.g. car, house, and student debts) and non-debt obligations (e.g. childcare, alimony, utilities, and maintenance etc.) are paid. This measure provides a better estimate of how much funds a borrower would have at his or her disposal to handle regular expenditures like food, clothing, and entertainment as well as unforeseen expenditures.
Under the ability to repay rule (ATR), a residual income test can be used as supporting evidence of a borrower’s ability to repay a loan, but it is not a definitive “bright line” proof of compliance with the rule. Participants in NAR’s 3rd Survey of Mortgage Originators were asked whether the addition of a “bright line” residual income test to the QM/ATR would improve their willingness to originate in the rebuttable presumption and/or non-QM spaces. Respondents who offered these products indicated that a residual income test would be most helpful in the rebuttable presumption space, roughly the well underwritten subprime sector, with 53.0% indicating that they would be either more likely or much more likely to originate. A definitive residual income test would also help in the non-QM space, but even there, lenders displayed a reluctance to originate products of lower quality.
New regulations have helped to restore traditional underwriting. However, regulators should remain amenable to financial innovations that could help to expand credit.