How VA Underwriting Tool Could Free Lenders from QM's Constraints

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Lenders should consider borrowing a guideline from the Department of Veterans Affairs to underwrite mortgages that do not meet the safe harbor test of the qualified mortgage rule, according to a new study by the Urban Institute.

The authors recommend using the VA residual income test, which consider how much a borrower has left to cover living expenses after paying major bills, including the mortgage. This would give lenders greater confidence that a borrower can repay the loan - and a way to rebut claims by defaulting borrowers that the lender didn't verify ability to repay. (Loans that do not meet QM standards have weaker protections against such lawsuits.)

"Adding a residual income test … could make lenders more willing to make loans whose risk level would, for other reasons, warrant a higher interest rate," the study says.

Laurie Goodman, Ellen Seidman and Jun Zhu authored the Urban Institute study, entitled "VA Loans Outperform FHA Loans. Why? And What Can We Learn?" Goodman is the director of the Urban Institute's Housing Finance Policy Center.

The Consumer Financial Protection Bureau has considered incorporating a residual income test into its QM regulations. But it has not endorsed a residual income test.

"The CFPB is continuing to monitor the market's adjustment to the new mortgage origination and servicing rules. The bureau will consider conducting a study on residual income and debt-to-income ratio in the future," a CFPB spokesman said.

The VA residual income test, a supplement to the more widely used debt-to-income ratio, is based on the borrower's after-tax income. The test looks at the borrower's ability to pay daily living expenses (food, clothing, transportation, medical care, etc.) in addition to their mortgage payments, utilities and condominium fees.

"The evidence from VA's experience suggests that when the CFPB reviews its mortgage rules in five years, residual income is worth another look," the Urban Institute report says.

VA guaranteed mortgages perform better than Federal Housing Administration Administration-insured loans, the study says, because the VA requires lenders to use its residual income test to qualify service members and veterans for home loans.

"Delinquency rates on VA loans have consistently been much lower than on FHA mortgages, even after correcting for borrower characteristics," according to the study.

The authors acknowledge the VA test makes it more difficult for low-income borrowers to qualify for a mortgage. However, the "test makes a big difference in default probabilities across all income groups who do take out VA loans. Even more telling, perhaps, is that the low-income borrowers who take out VA loans - those who pass the residual income screen - perform much better than their FHA counterparts."

The Consumer Mortgage Coalition, an industry trade group, has been urging the CFPB to come out with a residual income test for some time. "We have recommended that they use the VA test," said CMC executive director Anne Canfield.

One of CFPB's concerns about the VA test involves the nature of military service and its culture. Service members have the added pressure of losing their job or security clearance if they default on a mortgage.

However, the Urban Institute report indicates that most veterans don't get a mortgage while they are in uniform.

"Only 17% of VA borrowers were on active duty when they took out a loan in 2013," the study says. VA lenders originated 629,300 single-family loans in fiscal 2013, beating the previous record of 600,000 loans in fiscal 1994.

"If the CFPB were to implement a well-defined residual income test, such as the VA residual income test, lenders would likely begin to make significantly more loans that fall under the QM rebuttable presumption or non-QM loan classifications," Canfield said. "This would broaden the credit box and make credit available to more consumers, not just those who are well-heeled."

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