Why Subprime Mortgages Are Better Under Dodd-Frank

Subprime mortgages are coming back, slowly but surely. But while subprime loans remain an expensive form of financing there’s an argument to be made that today’s subprime mortgages are objectively better than the toxic loan products which were too common between 2000 and 2008.

While it may come as a surprise, subprime loans are allowed under Dodd-Frank. In fact, they can be defined as qualified mortgages, loans designed to encourage low-risk lending under Wall Street reform.

If you’re a lender you want to make qualified mortgages or what are called QMs. Such loans give lenders virtual immunity from borrower lawsuits and have other lender benefits as well. However, to get the goodies available with qualified mortgage status lenders must also meet a number of basic standards and it’s those standards which make today’s subprime loans far-less objectionable.

Interest Rates and Subprime Mortgages

One of the most important standards for qualified mortgages concerns interest rates. The rules say that when lenders meet all qualified mortgage requirements and interest rates are not more than 1.5 percent above the average prime offer rate (APOR) for a first lien (and 3.5 percent for a second lien) they automatically obtain certain benefits, including powerful protections against borrower lawsuits. Loans which meet all the qualified mortgage standards are said to be within the safe harbor created by Dodd-Frank.

But, first liens can STILL be qualified mortgages even if interest rates are more than 1.5 percent above the APOR.

“The Dodd-Frank Act,” says the Consumer Financial Protection Bureau, “does not prohibit high-cost mortgages from receiving qualified mortgage status. While the statute imposes a points and fees limit on qualified mortgages (3 percent, generally) that effectively prohibits loans that trigger the high-cost mortgage points and fee threshold from receiving qualified mortgage status, it does not impose an annual percentage rate limit on qualified mortgages. Therefore, nothing in the statute prohibits a creditor from making a loan with a very high interest rate such that the loan is a high-cost mortgage while still meeting the criteria for a qualified mortgage.”

Richard J Andreano, a Washington-based partner with the law firm of Ballard Spahr and a mortgage regulation authority, explains that when the interest rate is more than 1.5 percent above the APOR for a first lien but otherwise meets all qualified mortgage requirements the lender is protected under the concept of rebuttable presumption. This means it’s assumed that the loan is a qualified mortgage unless the borrower can prove that somehow the underwriting process was defective. For instance, imagine a situation where a borrower got a loan but was left house poor and could not meet overall living expenses because the lender grossly failed to properly underwrite the loan.

Are Subprime Mortgages Better Under Dodd-Frank?

Subprime loans that meet the qualified mortgage standards are objectively better than much of the financing which lead to the foreclosure crisis and the mortgage meltdown. The result is that while subprime loans are expensive and thus nobody’s first financing choice they are at least less risky under Dodd-Frank — and that’s good for borrowers, lenders, mortgage investors and bank shareholders.​

For instance, to be a qualified mortgage a loan must be fully documented. Points and fees cannot exceed 3 percent when the loan has an initial balance of $100,000 or more. Prepayment penalties are allowed for qualified mortgages but they cannot exceed 2 percent of the loan amount in year one, 2 percent in year two, 1 percent in year three and nothing thereafter.  The debt-to-income ratio is limited to 43 percent of the borrower’s gross monthly earnings — a qualifying mortgage requirement which effectively limits loan size and interest costs. Lenders must verify the borrower’s ability to repay the loan. Balloon loans cannot be qualified mortgages. Interest-only financing is out. Loans with a term of more than 30 years are forbidden and negative amortization is banned.

In the end, a subprime loan that’s also a qualified mortgage is today simply a loan with a higher interest rate that reflects the borrower’s impaired credit standing — and a loan without gotcha clauses or toxic elements.

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