What it means
Before 2008, many mortgages were made with little checking of income and with features that made repayment hard. After the crisis, US law required lenders to make a reasonable, good-faith judgement that the borrower can repay.
A loan that meets a list of tests is classed as a qualified mortgage. The tests exclude certain risky features.
These include negative amortisation, where the balance grows because payments do not cover interest, interest-only periods and large balloon payments at the end. The term cannot exceed 30 years, and total points and fees are capped as a percentage of the loan amount, with the cap adjusted for smaller loans.
Lenders also have to verify income, assets and debts, and consider the borrower's overall obligations. Earlier rules relied on a fixed limit for the ratio of debt to income, but the current approach places more weight on the loan's pricing relative to market rates.
The exact thresholds are set by the regulator and are updated over time. The benefit to the lender is legal certainty.
A qualified mortgage carries a presumption that the lender met the repayment-ability requirement, which lowers the risk of lawsuits and makes the loan easier to sell to investors. Borrowers benefit indirectly because standard products are cheaper and more widely available.
Not every loan is qualified, and non-qualified mortgages still exist. They serve people such as the self-employed, who may have irregular income that does not fit neat tests.
They may cost more because the lender has less legal protection. Borrowers feel the effect in everyday ways.
They are asked for payslips, bank statements and tax returns, and they may be told that a particular product is unavailable because it would not be qualified. Although this can feel intrusive, the checks are intended to prevent loans that the borrower cannot sustain.
In practice
Real-world examples.
Example
A first-time buyer applies for a $300,000 loan with a 30-year fixed rate. The lender verifies her salary, checks her existing debts and confirms the structure has no balloon payment, so the loan is classed as qualified.
Example
A mortgage originator tells a broker that a proposed interest-only product cannot be a qualified mortgage. The broker explains to the client that the lender will charge more or decline, because the product lacks legal protection.
Example
A bank's risk manager reviews its loan book and finds that nearly all new lending is qualified. She reports to the board that this lowers legal risk and makes loans easier to sell into the secondary market. She also notes that the few non-qualified loans are priced higher and tracked closely.
Formula
Calculation
Points and fees test: total points and fees must not exceed the cap percentage x loan amount
Suppose a buyer takes out a $400,000 mortgage and, for illustration, the cap is 3% of the loan. The maximum allowed in points and fees is 400,000 x 0.03 = $12,000. The lender charges an origination fee of $6,000, discount points of $2,500 and other counted charges of $1,000, a total of $9,500. That is 9,500 / 400,000 = 2.375%, which is below the cap, so this test is passed.Case study
Seen in the real world.
Oakridge Home Lending is an illustrative, fictional mortgage company that offered a product with a ten-year interest-only period. Its volumes were strong, but its legal adviser warned that the product could not be treated as a qualified mortgage.
The finance director estimated that the extra legal risk and the difficulty of selling the loans to investors would add about 0.5 percentage points to the cost of funds. On an illustrative loan book of $200,000,000, that came to $1,000,000 a year.
The board redesigned the product with fully amortising payments, so each payment reduced the balance. Volumes dipped slightly, but funding costs fell and the loans became easy to sell, which the company judged to be the better trade-off. Two years later the company reported fewer early payment defaults, which the risk committee credited to the stricter checks on income and the removal of the interest-only period.
Watch out
Common mistakes.
- Assuming a qualified mortgage is government-guaranteed, when the term describes the loan's features and the lender's checks, not a guarantee.
- Thinking all affordable mortgages are qualified, when some perfectly good loans fail a test, for example because of an interest-only period.
- Treating the debt-to-income ratio as the only test, when pricing, term, features and fees also matter.
Questions
People also ask.
What happens if a mortgage is not qualified?
The lender can still make it, but it faces more legal risk and may charge more or find it harder to sell the loan.
Who sets the rules?
Federal regulators set the standards, and they adjust thresholds from time to time.
Does the label protect the borrower?
Indirectly, because it excludes risky features, but it does not guarantee that the borrower can afford the loan in every circumstance.
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