Another Nail in the Coffin for Interest-Only Mortgages

Summary: A federal rule taking effect in January 2014 could put another nail in the coffin for interest-only mortgages. The so-called qualified mortgage (QM) rule prohibits a variety of ‘high-risk’ loan products and features, such as the interest-only loan.

Interest-only mortgages became wildly popular during the housing boom. These were scenarios where the borrower was allowed to pay only interest for the first few years, deferring the repayment of principal. Borrowers used these loans to lower the size of their monthly payments during the first few years of repayment.

During the housing boom of the early to mid 2000s, interest-only mortgages were often promoted as “affordability products.” They allowed borrowers to qualify for loans they wouldn’t be able to afford otherwise.

Today, these products are widely regarded as having contributed to the housing crisis. The Consumer Financial Protection Bureau (CFPB) labeled them as “toxic loan features,” and has taken steps to limit their use. The so-called qualified mortgage (QM) rule, which takes effect in 2014, expressly prohibits the use of these products. According to the CFPB’s new rules, an interest-only loan cannot be considered a qualified mortgage.

QM Rule: No Interest-Only Mortgages

According to a recent fact sheet published by the CFPB: “No interest-only loans, which are when a consumer only pays the interest for a specified amount of time so the principal does not decrease with payments [can be considered a qualified mortgage].” These new rules were announced on January 10, 2013, but they do not take effect until January 2014.

Lenders who make QM-compliant loans will receive some degree of legal protection against consumer lawsuits. There are two types of protection offered under the QM rule:

  • A legal safe harbor will be provided for qualifying loans with interest rates close to the prime rate. In this context, the prime rate is the one that banks offer to their most favorable customers. It is based on the rate offered by the Federal Reserve to banks.
  • The less protective “rebuttable presumption” will be available for higher-priced mortgages. In this context, a higher-priced home loan is one with an annual percentage rate (APR) more than 1.5 points higher than the prime rate. These are typically offered to borrowers with bad credit, higher debt levels, or other risk factors.

These protections create a powerful incentive for lenders to create loans that meet the definition of a qualified mortgage. The safe harbor clause, in particular, will be appealing to lenders fearing borrower lawsuits.

Strong Incentives for Making “Safer” Loans

Lenders can continue offering interest-only products, but they won’t receive any of the aforementioned legal protections on those loans. In this way, they are discouraged from offering such products.

It is expected that most lenders will stick to the QM guidelines for most of the home loans they generate, in order to secure the highly desirable legal protections that go along with the QM criteria. So, by extension, lenders will be less likely to generate interest-only mortgages.

And if they do offer such products, they will face additional rules on how they can qualify the borrower. Another CFPB rule finalized recently states that lenders must verify a borrower’s ability to repay the debt. This verification will come in the form of documents, and plenty of them — tax returns, W-2, bank statements, and the like. When measuring a consumer’s ability to repay an interest-only loan, the creditor must use “the fully indexed rate or any introductory interest rate, whichever is greater.”

The qualified mortgage rule also restricts the use of negative-amortization loans. This is a scenario where the principal balance grows over time, even when regular monthly payments are made. The rules also state that repayment terms cannot exceed 30 years.

According to the CFPB, these rule are designed to protect consumers from the kinds of risky lending practices “that contributed to many homeowners ending up in delinquency and foreclosure after the 2008 housing collapse.”

To learn more about the qualified mortgage or ability-to-repay regulations, please refer to the CFPB website (ConsumerFinance.gov). You may also visit our brand-new resource website dedicated to this subject: QualifiedMortgage.org.