How the Ability to Repay Works

The law grants the Consumer Financial Protection Bureau (CFPB) to administer rules and regulations that govern the mortgage industry. According to these rules, all loan originators must determine a borrower's current income and debt status. The lender must ensure the existing debt, potential mortgage debt, and other related expenses don't exceed a specified percentage of the borrower's current income.

Under the ability to repay rule (ATR), the law requires lenders to determine, consider and document the borrower's assets, income, credit history, employment, and monthly expenses.

The CFPB does not permit lenders to use an introductory ("teaser") rate to determine whether a borrower can reasonably repay a loan. For instance, if a specific mortgage comes with a low interest rate that will go up in subsequent years, the law requires the lender to do everything to determine if the borrower can also pay the expected higher interest.

Example of Ability to Repay

Jane visited her bank's local branch in Manhattan seeking a mortgage facility. Under the Dodd-Frank Wall Street Consumer Protection requirements, the bank gauges her ability to repay before offering the mortgage.

First, the bank looked into Jane's current income and existing debt status, and overall credit history. They sought to ensure that the potential mortgage debt and the existing debt and related expenses did not exceed the stated percentage of Jane's income.

Next, the bank verified Jane's employment status, other income, and her debt-to-income ratio. Based on these factors, Jane's bank made a reasonable, good-faith decision, arriving at the determination that Jane's ability to repay qualified her to receive the mortgage facility.

History of Ability to Repay

At the start of 2000, the US regulatory authorities noted that lenders often granted mortgages without finding out the borrower's ability to repay or whether the latter could afford to service the transaction. The authorities discovered that lenders often failed to verify the borrower's income.

In this state, lenders commonly offered lower initial interest rates that gradually adjusted and eventually lifted the monthly payments to an unaffordable level. As a result, the country witnessed an unprecedented mortgage crisis, leading to considerable recession. In time, the situation compelled the US Congress to respond to the problem, passing the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The Consumer Financial Protection Bureau's new "Ability to Repay Rule" officially went into effect on January 10, 2014.

Significance of Ability to Repay

Under the "Ability to Repay Rule," all creditors in the US must demonstrate a reasonable, good-faith effort (before or at the consummation stage) to ensure the borrower can repay the loan according to the set terms. This rule applies to every consumer credit transaction secured by a dwelling. The new rule exempts the following types of transactions (among others):

  • Home equity lines of credit, HELOC.
  • Temporary or "bridge" loans under 12 months.
  • Timeshare plan loans secured by interest.
  • Reverse mortgages.
  • 12 months or under construction-to-perm loans.

The CFPB outlines eight factors to determine whether a borrower reasonably demonstrates the ability to repay. Ultimately, based on these parameters, the CFPB expects that the lender will be well-positioned to make a reasonable, good-faith determination regarding the applicant's ability to repay a specific loan. Overall, the Dodd-Frank Act's effect restricts loans to those who are likely to have problems repaying.