I. INTRODUCTION
The Board of Governors of the Federal Reserve System (FRB) issued amendments to Regulation Z that are designed to curb abusive mortgage practices. The regulation is intended to prevent unscrupulous subprime lending and provides additional protections for “higher-priced” mortgage loans, including a requirement that lenders evaluate a borrower’s ability to repay the loan.
II. “HIGHER-PRICED” MORTGAGE LOANS
A. Definition of a “Higher-Priced” Loan
The regulation provides additional consumer protections to certain consumer residential mortgage loans (consumer-purpose, closed-end loans secured by a consumer’s principal dwelling), referred to as “higher-priced” loans. For purposes of the regulation, a “higher-priced” loan is a consumer residential mortgage loan with an APR greater than 1.50% over the “average prime offer rate” for first liens and 3.50% over the average prime offer rate for subordinate liens.
The Federal Reserve will use the Freddie Mac Primary Mortgage Market Survey (PMMS) in order to estimate the average prime offer rate, and will adjust the offer rate in the PMMS to reflect points as reported in the survey. The Federal Reserve will estimate and publish the APR rates for loan products that are not included in the PMMS.
Loans covered by the definition include home purchase loans, home-improvement loans, refinancings, and home equity loans. Home equity lines of credit, reverse mortgages, construction-only loans,bridge loans and loans that lack primarily a consumer purpose (i.e., investment loans) are not covered by the new regulation.
NOTE: The 1.50% threshold might inadvertently capture a portion of the prime market. Federal Reserve staff has acknowledged, however, that some prime loans, and especially prime jumbo loans, may be captured by the definition of “higher-priced” loans if disruptions in the mortgage market continue. Also, some Alt-A mortgages likely will become classified as higher-priced loans.
B. Ability to Repay from Sources other than Collateral
Creditors are prohibited from making “higher-priced” mortgage loans based on collateral without regard to a consumer’s repayment ability, including the consumer’s current and reasonably expected income, current and reasonably expected obligations, employment, and assets other than the collateral.
The creditor is responsible for assessing repayment ability at the time of consummation of the loan. A violation is not established if a borrower defaults because of significant expenses or income loss after consummation. A default does not create a presumption of a violation of the ability to repay requirement.
Lenders may look to a consumer’s current and reasonably expected income, employment, and assets other than the collateral in order to determine repayment ability. The regulation provides broad flexibility and gives many examples of the types of income, assets, and employment on which a creditor may rely. (See Supplement I to Part 226 - Official Staff Interpretations, Section 226.34(a)(4) for specific examples).
C. Verification of Income and Assets
A creditor must consider the consumer’s current obligations as well as mortgage-related obligations (i.e., taxes and insurance). Creditors must use third-party documents to verify assets or income, including expected income, that the creditor relies on in extending credit. Examples include W-2s, tax forms, payroll receipts, check-cashing receipts, remittance receipts, etc. The one type of document that is specifically excluded is a statement only from the consumer regarding the consumer’s assets and income.
D. Presumption of Compliance
The final rule provides that a creditor is presumed to have complied with the ability to repay requirement by completing all of the following steps:
1. Verify and document the consumer’s repayment ability.
2. Determine the consumer’s ability to make loan payments based on a fully-indexed rate and fully-amortizing payment (except in certain circumstances) that includes property taxes, HOA dues, homeowner’s insurance, and mortgage insurance premiums.
a) The relevant payment for underwriting is the largest payment that the consumer will have in seven years. Creditors may use a lower payment, but there would not be a presumption of compliance. Instead, compliance with the ability to repay requirement would be based on all of the facts and circumstances.
b) There is no presumption of compliance for a balloon payment with a term of less than seven years.
c) If the term of the loan is at least seven years, the creditor may retain the presumption of compliance if it under writes based on regular payments (not the balloon payment).
d) Loans with negative amortization within the first seven years are excluded from the presumption of compliance.
e) Interest-only loans can have a presumption of compliance.
3. Assess the consumer’s ability to repay using either a debt-to-income ratio or the income the consumer will have after paying debt obligations. The final rule does not provide quantitative thresholds for either of these metrics.
A borrower may rebut the presumption of compliance with evidence that the creditor disregarded repayment ability even though the creditor adhered to the steps described above. For example, evidence of a very high debt-to-income ratio and a very limited residual income could be sufficient to rebut the presumption, depending on all of the facts and circumstances.
1. Clarification of Higher-Priced Balloon Loans
The Federal Reserve issued a list of frequently asked questions regarding compliance with the repayment-ability rule for higher-priced balloon mortgage loans under Regulation Z. The FAQs, set forth below, along with excerpts from the Federal Reserve letter to officers and managers in charge of consumer affairs sections, clarify that the new Home Ownership and Equity Protection Act rules do not ban higher-priced balloon loans with terms of less than seven years.
SUBJECT: Short-Term Balloon Loans and Regulation Z Repayment Ability Requirement for Higher-Priced Mortgage Loans
This letter provides answers to questions we have frequently received regarding compliance with Regulation Z’s repayment ability rule for higher-priced balloon mortgage loans with terms of less than 7 years. In 2008, the Board revised Regulation Z… to prohibit creditors from making higher-priced mortgage loans “based on the value of the consumer’s collateral without regard to the consumer’s repayment ability as of consummation, including the consumer’s current and reasonably expected income, employment, assets other than the collateral, current obligations, and mortgage-related obligations.” This repayment ability rule and other consumer protections for mortgage loans took effect for applications received on or after October 1, 2009.
A creditor has a presumption of compliance with the repayment ability rule if the creditor follows certain procedures, including verifying the borrower’s income. Creditors extending balloon loans with terms of 7 years or more can have a presumption of compliance if the procedures are followed and if so, the creditor need not consider the borrower’s ability to repay the balloon payment. However, for some products a creditor cannot have a presumption of compliance even if it follows the specified procedures—these products include balloon loans with terms of less than 7 years (“short-term balloon loans”). Exclusion of short-term balloon loans from the presumption of compliance has led creditors to ask how they can make these loans and comply with the repayment ability rule.
Frequently Asked Questions and Answers
1. Question: Does the rule prohibit short-term balloon loans that are higher-priced mortgage loans?
Answer: No. However, the creditor must use prudent underwriting standards and, after considering consumers’ income, employment, obligations and assets other than the collateral, the creditor should determine that the value of the collateral (the home) is not the basis for repaying the obligation (including the balloon payment).
2. Question: Does that mean the creditor must verify that the consumer has assets and/or income at the time of consummation that would be sufficient to pay the balloon payment when it comes due?
Answer: No, such a requirement would effectively ban short-term balloon loans. If the Board had intended to ban these products it would have done so explicitly.
3. Question: What must the creditor do, then, to verify the borrower’s ability to repay a short-term balloon loan?
Answer: In addition to verifying the consumer’s ability to make regular monthly payments, a creditor should verify that the consumer would likely be able to satisfy the balloon payment obligation by refinancing the loan or through income or assets other than the collateral.
4. Question: How does the creditor verify, when it originates a short-term balloon loan, whether the consumer could qualify for a refinancing before the balloon payment is due?
Answer: The creditor has an affirmative duty to engage in prudent underwriting. Thus, the creditor should consider factors such as the loan-to-value ratio and the borrower’s debt-to-income ratio or residual income—all as of the time of consummation. A borrower with a high debt-to-income ratio, and/or with little or no equity in the property, will be less likely to be able to refinance the loan before the balloon payment comes due than a borrower with lower debt-to-income and loan-to-value ratios. The creditor is not required to predict the consumer’s future financial circumstances, interest rate environment, and home value.
E. Prepayment Penalties
1. The regulation imposes the following restrictions on prepayment penalties:
A. If loan payments can change on a “higher-priced” mortgage loan or a HOEPA loan within the first four years: prepayment penalties are prohibited.
B. If payments on “higher-priced” loan and a HOEPA loan cannot change for the first four years:
(1) The prepayment penalty is prohibited for two years after consummation.
(2) The prepayment penalty is prohibited if the same creditor or its affiliate makes the refinance loan.
C. For HOEPA loans only, the final rule retains the current prohibition of prepayment penalty provisions for loans with a debt-to-income ratio exceeding 50%.
2. Prepayment Penalties – Federal Reserve Board Interpretive Letter
Concerns have been raised regarding whether the provisions limiting prepayment penalties would apply to certain FHA loans. The Board’s staff commentary to Regulation Z provides that prepayment penalties include any “interest charges for any period after prepayment in full is made.” Under FHA programs, for purposes of allocating a consumer’s payment to accrued interest and principal, all loan payments are treated as being made on the scheduled due date so long as the payment is made prior to the expiration of the payment grace period (“monthly interest accrual amortization”). For example, if the consumer’s installment payment of principal and accrued interest is due on the first day of each month, the portion of the payment that will be allocated to accrued interest is the same, whether the creditor receives the payment on the due date, an earlier date (such as the 20th of the previous month), or shortly after the due date. Under this arrangement, consumers are not penalized for making payments during the grace period because all timely payments are considered to be received on the payment due date for purposes of calculating the accrual and payment of interest. At the same time, consumers that make early payments are treated as having paid on the payment due date and do not receive any reduction in interest due.
The same monthly interest accrual amortization method is also used when the consumer prepays the loan in full. Thus, if the consumer’s prepayment occurs 10 days before the payment due date, the consumer owes the same amount of interest as if the prepayment occurs on the payment due date. For federally-insured loans, due to the monthly interest accrual amortization method, HUD has not considered the payment of interest after the prepayment date as a prepayment penalty and has advised lenders that they need not disclose this practice as a prepayment penalty for these loans.
The Board’s staff commentary noted above provides guidance about prepayment penalties but does not address the specific situation involving loans that generally use the monthly interest accrual amortization method. In light of the guidance given by HUD regarding the payment of interest after the prepayment date, and the fact that the Board staff commentary on this issue does not expressly address this issue in the context of monthly interest accrual amortization, Board staff believes that lenders that use such an interest accrual method discussed above may continue to follow that practice. Lenders that engage in this practice would not be required to treat the interest charged from the date of prepayment until the next installment due date as a prepayment penalty for any purpose under Regulation Z. Staff also believes that lenders who have followed this practice in the past have acted reasonably and have complied in good faith with the prepayment penalty provisions of Regulation Z in this circumstance, whether or not the additional interest was treated or disclosed as a prepayment penalty under Regulation Z.
The Board has indicated that creditors may rely on the foregoing as an official interpretation of Regulation Z and, under TILA, liability will not apply to actions taken in good faith reliance on the guidance, to the same extent as if the guidance were set forth in the commentary to Regulation Z.
F. Escrow Accounts for Taxes and Insurance
“Higher-priced” loans secured by a first lien are required to have an escrow account for property taxes and homeowners insurance. Borrowers can opt out of the escrow account after the first twelve months (See exceptions to one-year escrow rule at Paragraph III, below). Payment amounts in advertisements that do not include taxes and insurance must disclose that fact in close proximity to the payment amount.
G. Evasion
Creditors are prohibited from structuring a closed-end mortgage loan as an open-end line of credit in order to avoid the additional protections provided to “higher-priced” mortgage loans, which would not apply to open-end lines of credit.
H. Effective Date
The effective date of the final regulation applying to “higher-priced” mortgage loans was October 1, 2009, with the exception of the escrow requirements described above for first-lien “higher-priced” loans and HOEPA-covered loans which took effect on April 1, 2010, and the escrow requirements for manufactured homes which took effect on October 1, 2010.
III. “HIGHER-PRICED” MORTGAGE LOAN ESCROW REQUIREMENTS
A. Introduction
The Federal Reserve Board (Board) issued a final rule to amend Regulation Z, which implemented the Truth in Lending Act (TILA). The final rule implemented Section 1461 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Section 1461 amended TILA to provide a separate, higher rate threshold for determining when the mandatory escrow account requirement applies to higher-priced mortgage loans that exceed the maximum principal obligation eligible for purchase by Freddie Mac. The final rule became effective on April 1, 2011, and is applicable only to those loans originated on or after that date.
The Bureau of Consumer Financial Protection (CFPB) subsequently published a final rule amending Regulation Z (Truth in Lending) to implement certain amendments to the Truth in Lending Act made by the Dodd-Frank Act.
Regulation Z currently requires creditors to establish escrow accounts for higher-priced mortgage loans secured by a first-lien on a principal dwelling. The CFPB final rule implements statutory changes made by the Dodd-Frank Act that lengthen the time for which a mandatory escrow account established for a higher-priced mortgage loan must be maintained. The rule also exempts certain transactions from the statute’s escrow requirement. The primary exemption applies to mortgage transactions extended by creditors that operate predominantly in rural or underserved areas, originate a limited number of first-lien covered transactions, have assets below a certain threshold, and do not maintain escrow accounts on mortgage obligations they currently service, with certain exceptions.
The final rule requires creditors to establish escrow accounts for certain mortgage transactions to help ensure that consumers set aside funds to pay property taxes, and premiums for homeowners insurance, and other mortgage-related insurance required by the creditor.
The rule became effective on June 1, 2013. The requirements of the final rule apply to transactions for which creditors receive applications on or after that date.
B. Summary of CFPB Final Rule
The final rule has three main elements:
The rule amends existing regulations that require creditors to establish and maintain escrow accounts for at least one year after originating a “higher-priced mortgage loan” to require generally that the accounts be maintained for at least five years.
The rule creates an exemption from the escrow requirement for small creditors that operate predominately in rural or underserved areas. Specifically, to be eligible for the exemption, a creditor must: (1) make more than half of its first-lien mortgages in rural or underserved areas; (2) have an asset size less than $2 billion; (3) together with its affiliates, have originated 500 or fewer first-lien mortgages during the preceding calendar year; and (4) together with its affiliates, not escrow for any mortgage it or its affiliates currently services, except in limited instances. Under the rule, eligible creditors need not establish escrow accounts for mortgages intended at consummation to be held in portfolio, but must establish accounts at consummation for mortgages that are subject to a forward commitment to be purchased by an investor that does not itself qualify for the exemption.
Finally, the rule expands upon an existing exemption from escrowing for insurance premiums (though not for property taxes) for condominiums, planned unit developments and other common interest communities to extend the partial exemption to other situations in which an individual consumer’s property is covered by a master insurance policy covering all dwellings.
C. Scope of Coverage – Higher Priced Mortgage Loans
If a mortgage loan (closed-end consumer credit transaction) is secured by a first mortgage on a consumer’s principal dwelling, it is a higher priced mortgage loan if the annual percentage rate exceeds the Average Prime Offer Rate (APOR) published by the CFPB by one and one-half (1.5) percentage points or more, unless the loan amount exceeds the maximum principal obligation eligible for purchase by Freddie Mac, in which case the loan is a jumbo loan. In the case of a jumbo loan, the allowable spread between the APR and the APOR is two and one-half points (2.5) or more. In the case of loans secured by a subordinate lien, the allowable spread between the APR and the APOR is three and one-half points (3.5) or more.
Under current rules, if a lender makes a higher priced mortgage loan (HPML), the lender is required to establish an escrow account for real estate taxes and insurance required by the lender. After one year, the lender may drop the requirement for the escrow at the borrower’s dated written request to cancel the escrow account.
D. Escrow Accounts
A creditor may not extend a higher-priced mortgage loan secured by a first-lien on a consumer’s principal dwelling unless an escrow account is established before consummation for payment of property taxes and premiums for mortgage-related insurance required by the creditor, such as insurance against loss of or damage to property, or against liability arising out of the ownership or use of the property, or insurance protecting the creditor against the consumer’s default or other credit loss.
1. Exemptions.
An escrow account need not be established for:
(A) A transaction secured by shares in a cooperative;
(B) A transaction to finance the initial construction of a dwelling;
(C) A temporary or “bridge” loan with a loan term of twelve months or less, such as a loan to purchase a new dwelling where the consumer plans to sell a current dwelling within twelve months; or
(D) A reverse mortgage transaction
2. “Rural” or “Underserved” Status
An escrow account also need not be established for a transaction if, at the time of consummation:
(A) During the preceding calendar year, the creditor and its affiliates together originated 2,000 or fewer covered transactions (consumer credit transaction secured by a dwelling...including any real property attached to a dwelling), secured by a first-lien; and
(B) As of the end of the preceding calendar year, the creditor had total assets of less than $2 billion (including the assets of the creditor's mortgage originating affiliates) with rounding to the nearest million dollars (the threshold was increased to $2.785 billion, effective January 7, 2026);
(C) During the preceding calendar year or during either of the two preceding calendar years if the application was received before April 1 of the current calendar year, a creditor extended a first-lien covered transaction secured by a property located in an area that is either "rural" or "underserved;"and
(D) Neither the creditor nor its affiliate maintains an escrow account for property taxes or insurance for any extension of consumer credit secured by real property or a dwelling that the creditor or its affiliate currently services, other than:
(1) Escrow accounts established for first-lien higher-priced mortgage loans on or after April 1, 2010, and before May 1, 2016; or
(2) Escrow accounts established after consummation as an accommodation to distressed consumers to assist such consumers in avoiding default or foreclosure.
The CFPB has extended the excluded period to May 1, 2016 to accommodate creditors who established escrow accounts after January 1, 2016, to comply with the previous requirement. Some of these creditors who did not previously satisfy the rural-or-underserved test may now qualify under the newly revised rural-or-underserved test. Creditors should not be precluded from qualifying under the newly revised test based solely on their having established escrow accounts subsequent to January 1, 2016, to comply with the requirements that the CFPB has revised.
For purposes of the final rule:
(A) A county is “rural” during a calendar year if it is neither in a metropolitan statistical area nor in a micropolitan statistical area that is adjacent to a metropolitan statistical area, as those terms are defined by the U.S. Office of Management and Budget and as they are applied under currently applicable Urban Influence Code (UICs) established by the United States Department of Agriculture’s Economic Research Service (USDA-ERS).
For example, if a creditor originated 90 covered transactions secured by a first-lien during 2013, the creditor meets this condition for an exemption in 2014 if at least 46 of those transactions are secured by first-liens on properties that are located in such counties.
A creditor may rely as a safe harbor on the list of counties published by the Bureau to determine whether a county qualifies as “rural” for a particular calendar year. https://www.consumerfinance.gov/policy-compliance/guidance/implementation-guidance/rural-and-underserved-counties-list . In addition, the definition of “rural” has been expanded to include census blocks that are not in an urban area as defined by the U.S. Census Bureau. A creditor may also rely on an automated address “look-up” tool available on the Census Bureau’s website or on the automated tool that the CFPB provides on its website. www.consumerfinance.gov/guidance/.
(B) A county is “underserved” during a calendar year if, according to Home Mortgage Disclosure Act (HMDA) data for the preceding calendar year, no more than two creditors extended covered transactions, secured by a first-lien five or more times in the county. A creditor may rely as a safe harbor on the list of counties published by the Bureau to determine whether a county qualifies as “underserved” for a particular calendar year. https://www.consumerfinance.gov/policy-compliance/guidance/implementation-guidance/rural-and-underserved-counties-list/
An escrow account must be established for any first-lien higher-priced mortgage loan that, at consummation, is subject to a commitment to be acquired by a person that does not meet the requirements for an exemption.
Examples. i. A county is considered “rural” for a given calendar year based on the most recent available UIC designations, which are updated by the USDA–ERS once every ten years. As an example, assume a creditor makes first-lien covered transactions in County X during calendar year 2014, and the most recent UIC designations have been published in the second quarter of 2013. To determine “rural” status for County X during calendar year 2014, the creditor will use the 2013 UIC designations. However, to determine “rural” status for County X during 2012 or 2013, the creditor would use the UIC designations last published in 2003.
ii. A county is considered “underserved” for a given calendar year based on the most recent available HMDA data. For example, assume a creditor makes first-lien covered transactions in County Y during calendar year 2013, and the most recent HMDA data is for calendar year 2012, published in the third quarter of 2013. To determine “underserved” status for County Y in calendar year 2013 for the purposes of qualifying for the “rural or underserved” exemption in calendar year 2014, the creditor will use the 2012 HMDA data.
The CFPB has provided clarification regarding the exemption from the requirement to establish escrow accounts for higher-priced mortgage loans for small creditors that extend more than 50 percent of their total covered transactions secured by a first lien in “rural” or “underserved” counties during the preceding calendar year. To prevent creditors that qualified for the exemption in 2013 from losing eligibility in 2014 or 2015 because of changes in which counties are considered rural while the CFPB is re-evaluating the underlying definition of “rural,” the CFPB is amending this provision to allow creditors to qualify for the exemption if they extended more than 50 percent of their total covered transactions in rural or underserved counties in any of the previous three calendar years (assuming the other criteria for eligibility are also met).
To qualify for the exemption, a creditor must have extended more than 50-percent of its total covered transactions secured by a first lien on properties located in “rural” or “underserved” counties during the proceeding calendar year. The provision thus prevents a creditor from losing eligibility for the exemption under the “rural” or “underserved” element of the test unless it is failed to exceed the 50-percent threshold three years in a row.
Creditors will qualify for the exemption if they qualified in any of previous three calendar years (assuming the other criteria for eligibility are also met). Finally, creditors that were previously ineligible for the exemption, but may now qualify in light of the changes, are not ineligible for the exemption because they had established escrow accounts for first-lien higher-priced mortgage loans (for which applications were received after June 1, 2013), as required when the final rule took effect and prior to these amendments taking effect. These amendments are effective for applications received on or after January 1, 2014.
The final rule adds a grace period allowing a creditor that does not meet one or more of the requirements for a small creditor (loan origination limit or asset-size limit) or a creditor that operates predominately in rural or underserved areas in the preceding calendar year to operate in certain circumstances, as a small creditor with respect to mortgage transactions with application received before April 1, of the then-current calendar year.
3. Loans Secured By a First Lien on Principal Dwelling.
An escrow account need not be established for any loan made by an insured depository institution and secured by a first lien on the principal dwelling of the consumer if:
(1) as of the preceding December 31, or, if the application for the transaction was received before April 1 of the current calendar year, as of either of the two preceding December 31, the insured depository institution or insured credit union had assets of $10 billion or less, adjusted annually for inflation;
(2) during the preceding calendar year, or, if the application for the transaction was received before April 1 of the current calendar year, during either of the two preceding calendar years, the creditor and its affiliates together extended no more than 1,000 covered transactions secured by a first lien on a principal dwelling ($12.179 billion to $12.485 billion) ;
(3) at least one covered transaction that the institution extended in the preceding calendar year (or in the year preceding that calendar year for applications received prior to April 1 of the current calendar year) was secured by a first lien on a property located in a rural or underserved area;
(4) the institution and its affiliates do not maintain an escrow for HPMLs, unless:
(a) the escrow was established after consummation as an accommodation to distressed consumers to assist such consumers in avoiding default or foreclosure; or
(b) the escrow was established at a time when the institution may have been required by the regulation to do so or was established after consummation as an accommodation to distressed consumers.
(NOTE: An institution that satisfies the exemption requirements is not required to establish escrow accounts for loans intended at consummation to be held in portfolio, but must establish escrow accounts at consummation for loan that are originated under a forward commitment for sale (i.e., loan not held in portfolio) unless the loan is otherwise exempt (for example, it is a reverse mortgage) or the acquirer is also eligible for either the small creditor or the insured institution exemption.
E. Cancellation of Escrow Account
A creditor or servicer may cancel an escrow account required by the final rule only upon the earlier of:
(A) Termination of the underlying debt obligation; or
(B) Receipt, no earlier than five years after consummation of a consumer’s request, to cancel the escrow account.
However, a creditor or servicer may not cancel an escrow account pursuant to a consumer’s request unless the following conditions are satisfied:
(A) The unpaid principal balance is less than 80 percent of the original value of the property securing the underlying debt obligation; and
(B) The consumer currently is not delinquent or in default on the underlying debt obligation.
F. Evasion of Rule
In connection with credit secured by a consumer’s principal dwelling that does not meet the definition of open-end credit, a creditor shall not structure a home-secured loan as an open-end plan to evade the requirements of the final rule.