New Rule Will Reinforce Conservative Home Lending

One of the questions hanging over the housing recovery is whether new mortgage underwriting rules that take effect Jan. 10 will make it harder to get loans.

Of particular concern is how the new rules will impact adjustable rate mortgages, which typically become more popular than fixed-rate loans as interest rates go up because they usually start out with a lower rate.

ARMs have been especially popular in California.

The new rules were designed to permanently outlaw deceptive and risky mortgages that produced the foreclosure crisis – types of mortgages which mostly don’t exist today.

“It puts in concrete the status quo, which is very conservative underwriting,” says Guy Cecala, publisher of Inside Mortgage Finance, a trade publication. “The expectation is it would get looser over time. (The new rules) say we are going to mandate conservative underwriting going forward.” He added that the rules “are not very attractive for ARMs,” not because they target that type of loan specifically, but because “ARMs have been more flexible, have had more moving parts” than 30-year fixed-rate loans.

Starting in January, all loans must comply with the Consumer Financial Protection Bureau‘s ability-to-pay rules. Under them, lenders must make sure a borrower can qualify for an ARM at the fully indexed rate. This is the interest rate index the loan is pegged to, plus a margin on that index.

If a loan is pegged at 2.25 percentage points more than the LIBOR rate, and LIBOR is 0.75 percent, the fully indexed rate is 3 percent. If the lender offers an introductory or teaser rate that is less than 3 percent, it cannot qualify the borrower based on that lower rate.

Lenders can get additional protection from lawsuits if they issue what is known as a qualified mortgage. A qualified mortgage cannot have negative amortization, interest-only or balloon payments.

More importantly, it requires lenders to qualify borrowers at the highest rate the mortgage can reach in the first five years. If a loan starts at 3 percent and is fixed for three years, but can go up as much as 2 percentage points a year thereafter, the buyer would have to qualify for the new loan at a rate of 7 percent. If an ARM is fixed for 5 years at 3 percent, only the 3 percent would apply, according to the bureau.

The lender must calculate what the borrower’s payment would be at the highest rate and make sure the borrower’s total debt payments (including principal, interest, taxes, insurance and payment on other debt) does not exceed 43 percent of monthly gross income.

In addition, points and fees on a qualified mortgage generally cannot exceed 3 percent of the loan amount.

Lenders can still make loans that do not meet the definition of a qualified mortgage, but they will have less protection if they are sued by borrowers or investors over a loan that goes into default.

One important wrinkle: Under a temporary provision, loans that are guaranteed by Fannie Mae and Freddie Mac and various federal agencies also will be considered qualified mortgages, but in some cases their guidelines differ from the qualified mortgage rules. For example, Fannie and Freddie sometimes guarantee loans that exceed 43 percent debt-to-income if borrowers look strong on other factors. Cecala did an analysis and found that 14 to 22 percent of Fannie and Freddie’s business exceeds 43 percent.

The 43 percent debt-to-income ratio could be a hindrance in the Bay Area. Jay Voorhees, a mortgage broker with JVM Lending in Walnut Creek, says most of his clients exceed 43 percent.

Doug Duncan, chief economist for Fannie Mae, says that in the past, when mortgage rates rose, more borrowers turned to ARMs, which kept the housing market going for a while.

The new rules “could be a constraint on demand that didn’t exist” in prior periods, he says.

Keith Gumbinger, a vice president with HSH Associates, says there could be some disruptions as lenders and borrowers get used to the new rules, which are quite complex. “I think there will be a period of change. The mortgage market has always proven adaptable, sometimes to the detriment of the market itself. There will be stumbling blocks to overcome.”

Kathleen Pender is a San Francisco Chronicle columnist. Net Worth runs Tuesdays, Thursdays and Sundays. E-mail: Blog: Twitter: @kathpender