Short Reset ARMS: The Special Rule

QUESTION 

I have a question about the annual percentage rate (APR) that needs to be calculated for adjustable-rate mortgages. 

Our adjustable mortgages can change the rate during the first five years after the first payment is due. You may have heard of these types of loans. They are called “short reset ARMS.” 

We price these QMs by using the General QM rule to calculate the APR. 

When we reviewed our loan servicing system, the auditor found that the programming rules for calculating prepaid interest were not explained in the rule descriptions stated for each rule. So, we need to have those descriptions. 

What is the interest rate used for calculating prepaid interest under the General Qualified Mortgage (QM) annual percentage rate (APR) calculation rule for certain adjustable-rate mortgages (ARMs) and short reset ARMs? 

ANSWER 

Your question obviously pertains to price-based General QMs. If you want to make a QM loan under the price-based General QM definition, you must calculate the APR to determine whether the loan satisfies the price-based General QM definition. 

Let me explain. The priced-based General QM definition contains a special rule for calculating the APR for loans where the interest rate may or will change within the first five years after the date on which the first regular periodic payment will be due. These loans are sometimes referred to as short-reset ARMs and step-rate loans. 

For loans with this characteristic, the creditor must treat the maximum interest rate that may apply during those five years as the interest rate for the loan's full term when determining the APR for purposes of the price-based QM definition. 

The special rule also applies for the purpose of determining whether the loan receives a conclusive or a rebuttable presumption of compliance with the ability-to-repay (ATR) requirement. 

For a loan to satisfy the price-based General QM definition, the loan APR cannot exceed the average prime offer rate (APOR) for a comparable transaction by the amounts set forth in the rule as of the date the interest rate is set. 

The difference between the loan’s APR and APOR – the “rate spread” – is also used to determine whether the loan will receive a conclusive or rebuttable presumption of compliance with the ATR requirement.

Now, concerning the interest rate to use for calculating prepaid interest under the special rule of General QM ARMS, per Regulation Z, the APR includes any prepaid interest, sometimes referred to as “odd-days” or “per diem interest.” Typically, mortgage interest is paid one month in arrears. 

For instance, if the first scheduled periodic payment due is on November 1, it will cover interest accrued in the preceding month of October. Thus, if the borrower consummates the mortgage loan on September 20, interest starts to accrue on September 20, and at consummation the consumer will typically prepay interest for the 11-day period through the end of September. That amount is prepaid interest. 

Sometimes, a creditor may provide the borrower a prepaid interest credit, often referred to as “negative prepaid interest.” Negative prepaid interest can result if consummation occurs after interest begins accruing for periodic payments. 

Thus, to apply negative prepaid interest to the example above, if the borrower instead consummates the mortgage loan on October 4, but the first scheduled periodic payment is due on November 1 and will cover interest accrued in the preceding month of October, then at consummation the creditor will typically credit the consumer for the preceding three days in October to offset some of that first scheduled periodic payment. That prepaid interest credit is also a component of the APR. 

Finally, take note, for purposes of calculating the APR for the General QM ARM’s special rule, the maximum interest rate that may apply during the five-year period after the date on which the first regular periodic payment will be due is used to calculate prepaid interest and negative prepaid interest. 

A creditor must use the maximum interest rate in the first five years for calculating the APR for purposes of the special rule, even if the creditor will use a different rate for calculating prepaid interest due at consummation.

Jonathan Foxx, Ph.D., MBA

Chairman & Managing Director

Lenders Compliance Group

Ability to Repay and Qualified Mortgage Rule: “Seasoned QM”

QUESTION
As a Compliance Manager, I am charged with keeping our policies and procedures current. We are a small lender in the Midwest. 

Recently, I have read that the ATR/QM rule has changed. We have a policy for this rule, and our Quality Control firm provides a report of any issues. We also rely on our LOS to ensure compliance. 

However, I have read that there were some changes recently. I have not been able to find a good summary of the changes. I wonder if you would offer a summary. 

By the way, we are an avid reader of your FAQs. Thank you for providing this service to everyone.

My question: would you please provide a summary of the new ATR/QM rule? 

ANSWER
I am grateful that you read our FAQs. We have been publishing them for many years. They are one of several expressions of our commitment to the mortgage community. We appreciate your continuing interest in our articles.

I will summarize the update to the Ability to Repay and Qualified Mortgage Rule (“Rule”). Keep in mind that often “the devil is in the details.” So, navigating the Rule requires careful consideration of the applicable statute's many components. If you need assistance in drafting this policy document, we can help. We’ll get it done painlessly and at minimum cost! Contact Us Here.

A quick but relatively cursory summary is provided in the Final Rule published in the Federal Register on December 29, 2020.[i] The effective date is March 1, 2021. The mandatory compliance date is July 1, 2021. The CFPB is applying the mandatory compliance date to the date on which a creditor receives a consumer’s QM loan application. Starting on the effective date (viz., March 1, 2021) and until July 1, 2021, compliance with the General QM Final Rule is optional.

First, I will provide the Final Rule and Official Interpretation published in the Federal Register. Get ready for a whole lot of terms, phrases, lawyerly language, and even a new term (viz., “Seasoned QM”). Here it is:

“With certain exceptions, Regulation Z requires creditors to make a reasonable, good faith determination of a consumer's ability to repay any residential mortgage loan, and loans that meet Regulation Z's requirements for “qualified mortgages” (QMs) obtain certain protections from liability. Regulation Z contains several categories of QMs, including the General QM category and a temporary category (Temporary GSE QMs) of loans that are eligible for purchase or guarantee by government-sponsored enterprises (GSEs) while they are operating under the conservatorship or receivership of the Federal Housing Finance Agency (FHFA). The Bureau of Consumer Financial Protection (Bureau) is issuing this final rule to create a new category of QMs (Seasoned QMs) for first-lien, fixed-rate covered transactions that have met certain performance requirements, are held in portfolio by the originating creditor or first purchaser for a 36-month period, comply with general restrictions on product features and points and fees, and meet certain underwriting requirements. The Bureau's primary objective with this final rule is to ensure access to responsible, affordable mortgage credit by adding a Seasoned QM definition to the existing QM definitions.”

To those of you who are not used to reading such texts, it can be an arduously annoying experience. Fortunately, I have spent a good part of my adult life immersed in these issuances. I guess I’m used to them. So, let me untangle the foregoing legalistic summary, provide a brief overview of the Rule, and hopefully thereby provide my own summary that is a bit less overtly fustian.

High Level Synopsis

The CFPB issued two final rules to amend the Ability-to-Repay/Qualified Mortgage (ATR/QM) Rule:

• The General QM Final Rule replaces the existing 43 percent debt-to-income (DTI) ratio limit in the General QM definition with price-based thresholds and makes other changes to the ATR/QM Rule.
•  The Seasoned QM Final Rule creates a new category of qualified mortgage, the Seasoned QM.

General QM Final Rule

The General QM Final Rule amends the General QM definition. Therefore, among other things, it replaces the existing 43 percent DTI limit with a price-based limit and removes Appendix Q as well as any requirements to use Appendix Q for General QM loans. However, the General QM Final Rule retains the Rule’s “consider and verify” requirements and clarifies how they apply under the revised General QM definition. The General QM Final Rule also retains the existing product-feature and underwriting requirements and limits on points and fees.

Price-Based Limit

A loan meets the revised General QM definition only if the Annual Percentage Rate (APR) exceeds the Average Prime Offer Rate (APOR) for a comparable transaction by less than the applicable threshold set forth in the General QM Final Rule as of the date the interest rate is set. Generally, this threshold is 2.25 percentage points.

But the General QM Final Rule provides higher thresholds for loans with smaller loan amounts, for certain manufactured housing loans, and for subordinate-lien transactions. The thresholds set forth in the General QM Final Rule are:

• For a first-lien covered transaction with a loan amount greater than or equal to $110,2603, 2.25 percentage points
• For a first-lien covered transaction with a loan amount greater than or equal to $66,156 but less than $110,260, 3.5 percentage points
• For a first-lien covered transaction with a loan amount less than $66,156, 6.5 percentage points
•  For a covered transaction secured by a manufactured home with a loan amount less than $110,260, 6.5 percentage points
• For a covered transaction secured by a manufactured home with a loan amount equal to or greater than $110,260, 2.25 percentage points
• For a subordinate-lien covered transaction with a loan amount greater than or equal to $66,156, 3.5 percentage points
• For a subordinate-lien covered transaction with a loan amount less than $66,156, 6.5 percentage points

If a loan’s interest rate may or will change in the first five years after the date on which the first regular periodic payment will be due, the creditor must treat the highest interest rate that may apply during that five years as the loan’s interest rate for the entire loan term when determining the APR for purposes of these thresholds. Additional information on determining the APR, the APOR, and the applicable threshold is available in the General QM Final Rule.

“Consider and Verify” Requirements

The revised General QM definition retains the “consider and verify” requirements.

First, it requires that creditors consider the consumer’s current or reasonably expected income or assets (other than the dwelling's value that secures the loan and any real property attached to that dwelling), debt obligations, alimony, child support, and DTI ratio or residual income.

Second, it requires that creditors verify the consumer’s current or reasonably expected income or assets (other than the value of the dwelling that secures the loan and any real property attached to that dwelling), as well as the consumer’s debt obligations, alimony, and child support. A creditor must verify such amounts using reasonably reliable third-party records and reasonable methods and criteria. A creditor may only consider amounts that it has verified in accordance with the verification requirements.

However, the General QM Final Rule does not prescribe specifically how a creditor must consider the monthly DTI ratio or residual income, a particular monthly DTI ratio or residual income threshold, or specific methods of underwriting that a creditor must use (other than to require that verification methods and criteria must be reasonable). Furthermore, the General QM Final Rule provides some flexibility for a creditor to consider additional factors relevant to determining a consumer’s ability to repay a loan.

To prevent uncertainty that may result from Appendix Q’s removal, the General QM Final Rule clarifies the “consider and verify” requirements in the revised General QM definition. The General QM Final Rule includes a list of specific verification standards that the creditors may use to meet the revised General QM definition’s verify requirement. If a creditor satisfies the verification standards in one or more specified manuals, the creditor has a safe harbor for compliance with the verification requirement in the revised General QM definition.

Seasoned QM Final Rule

The Seasoned QM Final Rule creates a new category of QMs, the Seasoned QM. A residential mortgage loan is a Seasoned QM and receives a safe harbor from liability under the ATR/QM Rule if

(1) the loan satisfies certain product restrictions,

(2) does not exceed a points-and-fees limit,

(3) satisfies underwriting requirements, is

(4) held in portfolio until the end of the seasoning period (subject to certain enumerated exceptions), and

(5) meets certain performance standards at the end of the seasoning period.

A loan made by any creditor, regardless of size, is eligible to become a Seasoned QM if, at the end of the seasoning period, it meets the requirements in the Seasoned QM Final Rule. Loans that satisfy another QM definition at consummation also can be Seasoned QM loans, as long as the requirements for Seasoned QMs are met.

Determination of APOR upon Relock of Loan

QUESTION

We are having an internal debate as to how the HPML APOR is determined when a rate lock has expired and the rate is relocked.

When the rate lock expires, we need to relock the interest rate which provides a new lock in date, which in turn results in a new APOR being used for the purposes of the HPML test. This can be problematic in an improving market. For example, in instances in which we have relocked the interest rate and terms identical to those set forth in the expired lock, the new APOR is lower and the loan may now fail the HPML test. This situation often arises when the loan officer allows the rate to expire in order to enable the loan officer to relock at the same rate and pricing without charging the borrower a rate lock extension fee.  

Our Secondary Department has determined that the APOR for the HPML test should be based on the rate sheet date used to price the loan as that is how the rate is “set”. 

Can you please provide us with some guidance as to the date to be used?  Also, if the rate lock has expired completely, can we simply extend the rate lock keeping the same rate/pricing and lock in date, as opposed to relocking the loan? 

ANSWER

For the purposes of the HPML test, the APOR should be based on the date the rate is actually locked pursuant to the last rate lock agreement. 

See Official Commentary to paragraph 35(a):

“2. Rate set. A transaction's annual percentage rate is compared to the average prime offer rate as of the date the transaction's interest rate is set (or “locked”) before consummation. Sometimes a creditor sets the interest rate initially and then re-sets it at a different level before consummation. The creditor should use the last date the interest rate is set before consummation.”

See also FFIEC’s “Data Requirements for the Rate Spread Calculator”:

“If an interest rate is set pursuant to a "lock-in" agreement between the lender and the borrower, then the date on which the agreement fixes the interest rate is the date the rate was set. If a rate is re-set after a lock-in agreement is executed (for example, because the borrower exercises a float-down option or the agreement expires), then the relevant date is the date the rate is re-set for the final time before closing. If no lock-in agreement is executed, then the relevant date is the date on which the institution sets the rate for the final time before closing."

As to “extending” a rate, when the rate lock agreement has completely expired instead of relocking, you cannot do so. If the rate has expired completely, the loan has started to float.  Thus, you need to relock. 

Joyce Wilkins Pollison

Director/Legal & Regulatory Compliance

Lenders Compliance Group