Key Takeaways
- The Ability-to-Repay (ATR) rule requires lenders to verify eight factors including income, assets, debts, credit history, and DTI before making a loan
- Qualified Mortgages (QM) provide legal safe harbor and must have points/fees <= 3% for loans >= $100,000, no negative amortization, term <= 30 years, and fully amortizing payments
- Front-end DTI (housing ratio) compares housing expenses to gross income with a traditional benchmark of 28%, while back-end DTI includes all debts with benchmark of 36%
- GSE QM loans allow DTI up to 45% (or 50% with strong compensating factors) while General QM uses a 43% DTI limit
- Automated underwriting systems (DU and LPA) evaluate loan applications in seconds and provide conditional approvals with required documentation lists
- Manual underwriting requires human review for loans that don't pass automated systems and applies stricter compensating factor requirements
Underwriting Guidelines
Mortgage underwriting determines whether a borrower qualifies for a loan. Understanding the Ability-to-Repay (ATR) rule and Qualified Mortgage (QM) standards is essential for MLO exam success.
Ability-to-Repay (ATR) Rule
The Ability-to-Repay rule requires lenders to make a reasonable, good-faith determination that a borrower can repay their mortgage. This rule was created by the Consumer Financial Protection Bureau (CFPB) under the Dodd-Frank Act.
Eight ATR Factors
Lenders must consider and verify at least eight factors:
| # | Factor | What Lender Verifies |
|---|---|---|
| 1 | Current income or assets | Pay stubs, tax returns, bank statements |
| 2 | Current employment status | Verification of employment (VOE) |
| 3 | Monthly mortgage payment | Calculate P&I, taxes, insurance, HOA |
| 4 | Monthly payments on other loans | Credit report |
| 5 | Monthly payment for mortgage-related obligations | Property taxes, insurance, HOA |
| 6 | Current debt obligations | Credit report, alimony, child support |
| 7 | DTI ratio or residual income | Calculate housing + all debts vs. income |
| 8 | Credit history | Credit report, scores |
ATR Applies To
- All residential mortgage loans
- Primary residence, second homes, investment properties
- Purchase, refinance, and home equity loans
ATR Exemptions
Some loans are exempt from ATR requirements:
- Reverse mortgages (HECMs)
- Temporary or bridge loans (12 months or less)
- Construction phase loans
- Timeshare loans
- Certain community development loans
Qualified Mortgages (QM)
A Qualified Mortgage is a category of loans that meet specific requirements and provide legal protection to lenders. QM loans are presumed to comply with ATR requirements.
QM Requirements
| Requirement | Standard |
|---|---|
| Points and Fees | <= 3% of loan amount (for loans >= $100,000) |
| Loan Term | 30 years or less |
| Negative Amortization | Not permitted |
| Interest-Only | Not permitted |
| Balloon Payments | Not permitted (with limited exceptions) |
| Fully Amortizing | Required - must pay principal over loan term |
| Verification | Income/assets must be verified |
Points and Fees Thresholds
| Loan Amount | Maximum Points/Fees |
|---|---|
| >= $100,000 | 3% |
| $60,000 - $99,999 | $3,000 |
| $20,000 - $59,999 | 5% |
| $12,500 - $19,999 | $1,000 |
| < $12,500 | 8% |
Types of Qualified Mortgages
| QM Type | DTI Limit | Description |
|---|---|---|
| GSE/Agency QM | Up to 50% | Loans eligible for Fannie/Freddie/FHA/VA/USDA |
| General QM | 43% | Loans meeting General QM standards |
| Seasoned QM | None (performance-based) | Loans held 36 months with no 60+ day delinquencies |
Safe Harbor vs. Rebuttable Presumption
| Category | Rate Threshold | Legal Protection |
|---|---|---|
| Safe Harbor QM | APR <= APOR + 1.5% | Strong presumption of compliance |
| Rebuttable Presumption QM | APR > APOR + 1.5% | Compliance can be challenged |
APOR = Average Prime Offer Rate (published weekly by CFPB)
Debt-to-Income (DTI) Ratios
DTI ratios measure a borrower's monthly debt obligations compared to their gross monthly income.
Two Types of DTI
| Ratio | Also Called | Formula |
|---|---|---|
| Front-End DTI | Housing ratio | Housing expenses / Gross income |
| Back-End DTI | Total DTI | All monthly debts / Gross income |
Front-End (Housing) DTI
Includes:
- Principal and interest (P&I)
- Property taxes (T)
- Homeowner's insurance (I)
- HOA fees (if applicable)
- Mortgage insurance (if applicable)
Traditional Benchmark: 28%
Back-End (Total) DTI
Includes everything in front-end PLUS:
- Minimum credit card payments
- Auto loan payments
- Student loan payments
- Personal loans
- Child support/alimony
- Other monthly obligations
Traditional Benchmark: 36%
DTI Limits by Program
| Loan Program | Maximum DTI |
|---|---|
| Conventional (with AUS approval) | 45-50% |
| FHA | 43% (up to 50% with compensating factors) |
| VA | No maximum (residual income required) |
| General QM | 43% |
| GSE/Agency QM | Based on AUS approval |
DTI Calculation Example
Borrower's Monthly Finances:
- Gross monthly income: $8,000
- Proposed mortgage payment (PITI): $1,800
- Car payment: $450
- Student loans: $350
- Credit cards (minimum): $200
Calculations:
- Front-End DTI: $1,800 / $8,000 = 22.5%
- Back-End DTI: ($1,800 + $450 + $350 + $200) / $8,000 = $2,800 / $8,000 = 35%
Automated Underwriting Systems (AUS)
Most loans are evaluated using automated underwriting systems before manual review.
Major AUS Platforms
| System | Owner | Used For |
|---|---|---|
| Desktop Underwriter (DU) | Fannie Mae | Conventional, FHA |
| Loan Product Advisor (LPA) | Freddie Mac | Conventional |
| GUS | USDA | USDA loans |
| VA LAPP | VA | VA loans |
How AUS Works
- Data Entry: Loan officer inputs application data
- Analysis: System evaluates credit, income, assets, collateral
- Finding: System issues approval or referral
- Conditions: System generates required documentation list
AUS Findings
| Finding | Meaning |
|---|---|
| Approve/Eligible | Loan meets guidelines, likely to close |
| Approve/Ineligible | May qualify with different product |
| Refer with Caution | Requires manual underwriting |
| Out of Scope | Cannot be evaluated by AUS |
Benefits of AUS
- Speed: Decisions in seconds vs. hours/days
- Consistency: Same criteria applied uniformly
- Documentation: Clear list of required items
- Risk Assessment: Statistical analysis of default probability
Manual Underwriting
Manual underwriting occurs when a loan cannot be approved through AUS or lender policy requires human review.
When Manual Underwriting Required
- AUS returns "Refer" finding
- No credit score available
- Loan doesn't fit AUS parameters
- Lender overlay requires it
Manual Underwriting Requirements
Manual underwriting typically requires:
- Lower DTI limits (36-45% vs. 50%)
- More reserves (2-6 months PITI)
- Stronger compensating factors
- Additional documentation
- More stringent credit review
Compensating Factors
Compensating factors are positive characteristics that offset weaknesses in an application.
Common Compensating Factors
| Factor | How It Helps |
|---|---|
| Large down payment | Reduces LTV, demonstrates financial capacity |
| Cash reserves | Proves ability to handle emergencies |
| Minimal DTI increase | Payment similar to current housing |
| Strong credit history | Demonstrates payment reliability |
| Stable employment | Long tenure, consistent income |
| Residual income | Money left after paying all expenses |
| Cash-out reduction | Refinancing to lower rate/payment |
Using Compensating Factors
| Weakness | Potential Compensating Factor |
|---|---|
| High DTI | Large reserves, strong credit |
| Lower credit score | Large down payment, low DTI |
| Limited credit history | Large reserves, stable employment |
| Self-employment | Two+ years same business, strong reserves |
Documentation Types
| Documentation Level | Description |
|---|---|
| Full Documentation | Tax returns, pay stubs, W-2s, bank statements |
| Reduced Documentation | Fewer documents, typically for strong files |
| Bank Statement | 12-24 months of bank statements for self-employed |
| Asset Depletion | Qualifies on assets rather than income |
Non-QM Documentation
Non-QM loans may use alternative documentation:
- Bank statements (12-24 months)
- 1099 income only
- Asset-based qualification
- DSCR (debt service coverage ratio) for investors
Key Takeaways
- The ATR rule requires verification of eight borrower factors
- Qualified Mortgages must be fully amortizing with term <= 30 years
- QM points/fees cannot exceed 3% for loans $100,000+
- Front-end DTI = housing expenses only; back-end DTI = all debts
- Traditional DTI benchmarks are 28%/36% but QM allows higher
- AUS provides fast, consistent loan decisions
- Compensating factors can offset application weaknesses
Under the ATR rule, which of the following is NOT one of the eight factors lenders must consider and verify?
For a $400,000 Qualified Mortgage, what is the maximum amount of points and fees the lender can charge?
A borrower has gross monthly income of $10,000, a proposed mortgage payment (PITI) of $2,500, a car payment of $500, and student loans of $300. What is their back-end DTI ratio?