Findings from recent exams suggest that banks may not fully understand Regulation Z’s ability-to-repay (ATR) rules regarding balloon payments. These rules are relevant for Ninth District banks that continue to originate mortgage loans with balloon payments, particularly because recent regulatory changes affect the qualified mortgage options for small creditors. In this update, we address typical errors by clarifying the ATR requirements applicable to balloon payment loans.
Balloon Payment Mortgage Loans
Regulation Z requires banks to evaluate the applicant’s ATR on most mortgage loans, including mortgage loans with a balloon payment (a payment more than two times the regular periodic payment). Most applicants cannot meet the ATR requirement when the creditor includes the balloon payment in the assessment. Specifically, the borrower does not have the income necessary to cover the payments that result when the balloon payment is included in the calculation. Banks have limited alternatives in this situation. Creditors that originate balloon loans must meet certain criteria in Regulation Z to exclude the balloon payment from the ATR calculation. Examiners identified several instances where banks did not follow these criteria as intended. We detail these cases to help creditors avoid making similar errors.
ATR Determination on Balloon Payment Loans
Non-qualified mortgage loans. Some lenders set up balloon payment loans with terms that were too short to allow them to exclude the balloon payment from the ATR calculation. All creditors may determine an applicant’s ATR on a mortgage loan with a balloon payment by using only the monthly periodic payment. Creditors can use this calculation method if the loan term is at least 60 months from the first payment. Typically, loans eligible for this calculation method have loan terms of 61 or 62 months depending on the number of days until the first payment is due. This option is not available for higher-priced loans.1
Qualified mortgage loans. Some lenders intended to meet the balloon payment qualified mortgage (BPQM) standard, which includes requirements for both the creditor and the loan, but did not meet all the qualification criteria. Only small creditors may originate one of the BPQMs described below.
Effective January 1, 2016, a creditor must meet the following criteria to be considered a small creditor:
- Together with its affiliates, originated 2,000 or fewer first-lien, covered transactions2 during the last year (not including portfolio loans) and
- Had assets less than $2.060 billion as of the end of the preceding year (affiliate assets are included in this total if the affiliate regularly extends covered first-lien residential loans), or
- If the application is received between January 1 and April 1 of the current year, had assets less than $2.060 billion as of the end of either of the two preceding years.
Permanent balloon payment qualified mortgage. Small creditors that primarily lend in rural or underserved areas are eligible for the permanent BPQM, which allows them to exclude the balloon payment in the ATR calculation. Effective January 1, 2016, the lender must have extended more than 50 percent of its first-lien covered transactions on properties located in rural or underserved areas during the preceding calendar year. Previously, a lender could meet this test if 50 percent of its lending in any one of the preceding three years was in rural or underserved areas. A rural area can be either a county defined as rural or a census tract not in an urban area as defined by the U.S. Census Bureau.
Temporary balloon payment qualified mortgage. All small creditors, regardless of the locations of their loans, are eligible to originate the temporary BPQM until it expires on April 1, 2016. After that date, the rural and underserved standard must be met for lenders to be eligible for the permanent BPQM standard.
The loan must also meet all of the following requirements in order to be a BPQM:
- Have a term between five and 30 years.
- Have a fixed interest rate.
- Have substantially equal payments (other than the balloon payment) that do not result in negative amortization and are based on an amortization period of 30 years or less.
- Be held in portfolio for three years after origination.
- Have points and fees within the specified limits for qualified mortgages.
Lenders that choose to originate adjustable rate mortgages (ARMs) rather than balloon loans should continue to follow the applicable ATR requirements of Regulation Z, regardless of creditor size or location of lending. Lenders that originate balloon loans should ensure that these loans meet either the ATR requirements for non-qualified mortgages or the standards for BPQMs, including evaluating whether the bank will meet the small creditor and rural and underserved standards for any applications received on or before April 1, 2016.
The CFPB issued rule amendments on October 2, 2015. The rule is available at www.federalregister.gov/articles/2015/10/02/2015-24362/amendments-relating-to-small-creditors-and-rural-or-underserved-areas-under-the-truth-in-lending-act.
1 A higher-priced loan has an annual percentage rate that exceeds the average rate offered to prime borrowers by more than 1.5 percentage points in the case of a first lien and by more than 3.5 for a subordinate lien. For example, a first-lien loan originated in August 2015 with a rate of about 5.5 percent or higher is higher-priced.
2 1026.43(b)(1) A covered transaction is a closed-end, consumer credit transaction secured by a dwelling other than a reverse mortgage, a temporary loan, or a loan secured by an interest in a timeshare.