Owning a home is and has been the American dream for decades. Most people go to a lender and inquire about how to qualify for a mortgage. They want to know how much house they can easily and safely afford. Today, a standard in the mortgage industry called the Qualified Mortgage (QM) makes it easier for consumers to pay off a home with less risk of defaulting on the loan. Take a look at some of the history that led to the creation of the QM and how it works.
In the 1990s, politicians were determined to pass laws so everyone could own a home. However, they neglected to ensure that safeguards were put in place to protect consumers from lenders who might take advantage of them through unethical loan terms. There were few protections for lenders from lawsuits by borrowers who did not qualify to buy a home using typical lending standards.
Subprime mortgages had been around for many years but were rarely used. However, in the early 2000s, the creation of pooled mortgage-backed securities (MBS) encouraged an increase in subprime 100% loans, in which a borrower could get an 80% first loan and a 20% second loan and not have to put any money down. This led to a housing bubble with home prices skyrocketing, which finally crashed in 2008 when home prices declined and the MBS market collapsed. Approximately 8.6 million people lost their jobs between 2008-2009.
In 2008, 861,664 families lost their homes to foreclosure; by 2009, another 2.8 million homes were foreclosed. Many who took out 100% loans (no down payment required) owed more on their mortgage than the house was worth and simply moved out. Some had taken out Principal and Interest-only loans and didn’t understand they needed additional money for taxes and insurance.
In 2011, the Federal Reserve proposed a rule called the Qualified Mortgage to bolster the housing market. This rule applies to a type of loan with certain, less risky features to ensure that consumers can reasonably be expected to repay their loans. The newly created Consumer Financial Protection Bureau (CFPB) took over responsibility for the Qualified Mortgage rule in 2013 and it became effective in 2014.
How Qualified Mortgages Work
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 amended the 1968 Truth in Lending Act (TILA) to establish ability-to-repay requirements for most residential mortgage loans. The Qualified Mortgage is a category of loan requirements by which lenders may presume that a borrower can repay the loan without missing payments and ultimately defaulting. There are a series of rules that the lender must follow and requirements that the borrower must meet to be eligible for a Qualified Mortgage. These include:
Ability-to-Repay Rule
The Ability-to-Repay Rule for a qualified mortgage mandates that a lender must make a reasonable and good faith determination that a potential borrower can repay a loan before giving that person a residential mortgage.
To make this determination, the lender must consider and document a person’s entire financial status, including income, assets, debt-to-income ratio, employment history, credit history and monthly expenses.
Suppose the lender provides the borrower with an adjustable rather than fixed interest rate. In that case, they cannot simply use a low starting rate, sometimes called the “teaser rate,” to determine qualification. They must also calculate eligibility using the higher rate the loan will become in later years.
This qualified mortgage rule protects borrowers from getting in over their heads on a loan they cannot afford. There are many costs associated with mortgages and the lender must ensure that the borrower can afford them all. It also protects lenders from accusations of “predatory lending” (unfair or abusive lending practices to take advantage of a borrower) should they default on the loan at some point.
Restrictions on Risky Loan Features
To minimize the potential of the borrower defaulting on a residential mortgage, qualified mortgages do not permit higher-risk loan features such as:
- An “Interest-only” period where only interest, but no principal on the loan, is paid down.
- “Negative amortization,” which allows the loan principal to increase over time, even as the borrower makes regular payments.
- “Balloon Payments,” a much larger-than-usual payment at the end of the loan term.
- Loan terms longer than 30 years.
The Federal Housing Administration (FHA), in particular, has cracked down on mortgage lenders who have violated these rules in the past by withdrawing FHA approval, suspending them or putting them on a probationary period.
Pricing Limits
Another way that the CFPB protects consumers from default is by mandating that the annual percentage rate (APR) on a qualified mortgage must remain within a particular threshold, depending on the type or size of the loan.
In December 2020, the CFPB established pricing thresholds based on the spread of a loan’s APR compared to the Average Prime Offer Rate (APOR). The APOR is a benchmark rate based on average interest rates, fees and other mortgage terms offered to highly qualified borrowers.
In other words, the APR (sum of all points and fees plus the interest rate) cannot be significantly above the average annual interest rate.
Limits on Points and Fees
Points are prepaid interest at closing or rolled into the loan that borrowers pay to lower the interest rate on a mortgage. However, limiting the points and fees on a mortgage is a way to keep costs down for the borrower. One point on a mortgage usually costs 1% of the mortgage amount and will reduce the interest rate over the life of the loan by 0.25%.
In 2024, the total points and fees threshold is:
3% of the total loan amount for a loan greater than or equal to $130,461
$3,914 for a loan amount of $78,277 or more but less than $130,461
5% of the total loan amount for a loan of $26,092 or more but less than $78,277
$1,305 for a loan amount of $16,308 or more but less than $26,092
8% of the total loan amount for a loan less than $16,308.
General-Definition Qualified Mortgages
The General Qualified Mortgage is commonly referred to as a Qualified Mortgage. As cited above, they have strict rules to ensure borrowers can afford to make monthly mortgage payments. The key points are reasonable fees, safe features, ability-to-pay and debt limits – generally no more than 43% of gross income.
Small-Creditor Qualified Mortgages
A small-creditor Qualified Mortgage is a loan designed for credit unions, community banks and other smaller lenders. The rules for these loans are more flexible than those for other Qualified Mortgages and the loans stay with the lender rather than being sold.
There are four requirements for the lender to make these loans:
- The lender must have less than $2 billion in assets and make fewer than 500 loans yearly.
- The lender must keep the loan and not sell it to big investors
- Flexible rules for local and smaller communities
- Loans made in some rural areas may include a large balloon payment at the end
What Is A Nonqualified Mortgage?
A Nonqualified Mortgage (non-QM) is any mortgage that does not meet the qualified mortgage definition set by the Consumer Financial Protection Bureau. Non-QM loans are available for borrowers who don’t qualify for a traditional mortgage, such as persons with irregular income, low credit scores or multiple income streams. Two examples of non-qualified mortgage lenders found online are CrossCountry Mortgage and Angel Oak Mortgage Solutions.
The non-qualified mortgage has different eligibility requirements than the Qualified Mortgage and the interest rates and closing costs are usually higher. The non-qualified mortgage uses bank statements or asset consideration as alternative underwriting methods. Since the qualified mortgage model is not utilized, the lender assumes more risk for issuing the loan.
Conclusion
The qualified mortgage definition is a loan with strict rules and requirements to ensure that consumers can afford their residential mortgage payments and are not at risk of default. It began as a way to temper the number of foreclosures that were crushing the real estate market. A Qualified Mortgage restricts the number of points a lender can charge, puts a ceiling on interest rates, limits high-risk loan features and, most importantly, ensures that a borrower can repay the loan based on current income and debt levels.
In addition to protecting the borrower, it protects the lender from being accused of making a predatory loan because if the lender documents everything required for a Qualified Mortgage, they can prove to the CFPB that everything was done according to the law.