Compliance Blog

Posted by Anthony Demangone

Earlier this week, the Fed issued a nice guidance document to clear some confusion on higher priced mortgage loans that centered on balloon loans and verifying the borrower's ability to repay. Access the guidance here.  Before the guidance, many concluded that HPMLs with short-term balloons (less than 7 years) were a no-no.  The Fed clarifies that this isn't the case.

I'd keep an eye out for this type of guidance moving forward.  With virtually every aspect of Reg Z being amended, the Fed will have to clarify issues that pop up.  And many will.  I'd bet on it.

Here's the Q and A portion of the guidance:

Frequently Asked Questions and Answers

1. Question: Does the rule prohibit short-term balloon loans that are higher-priced mortgage loans?

Answer: No. However, the creditor must use prudent underwriting standards and, after considering consumers’ income, employment, obligations and assets other than the collateral, the creditor should determine that the value of the collateral (the home) is not the basis for repaying the obligation (including the balloon payment).

2. Question: Does that mean the creditor must verify that the consumer has assets and/or income at the time of consummation that would be sufficient to pay the balloon payment when it comes due?

Answer: No, such a requirement would effectively ban short-term balloon loans. If the Board had intended to ban these products it would have done so explicitly.

3. Question: What must the creditor do, then, to verify the borrower’s ability to repay a short-term balloon loan?

Answer: In addition to verifying the consumer’s ability to make regular monthly payments, a creditor should verify that the consumer would likely be able to satisfy the balloon payment obligation by refinancing the loan or through income or assets other than the collateral.

4. Question: How does the creditor verify, when it originates a short-term balloon loan, whether the consumer could qualify for a refinancing before the balloon payment is due?

Answer: The creditor has an affirmative duty to engage in prudent underwriting. Thus, the creditor should consider factors such as the loan-to-value ratio and the borrower’s debt-to-income ratio or residual income—all as of the time of consummation. A borrower with a high debt-to-income ratio, and/or with little or no equity in the property, will be less likely to be able to refinance the loan before the balloon payment comes due than a borrower with lower debt-to-income and loan-to-value ratios. The creditor is not required to predict the consumer’s future financial circumstances, interest rate environment, and home value.