We do not believe that a balloon loan with a term of less than five years could be considered a qualified mortgage (QM). It may be possible to make a balloon loan with a term of less than five years, but it would have to otherwise satisfy the general ability-to-repay (ATR) requirements. Also, as discussed below, a renewal of an existing balloon loan that is not considered a refinancing may not be subject to the new ATR requirements.
QMs with Balloon Features
Generally, a qualified mortgage cannot include a balloon payment feature. 12 CFR 1026.43(e)(2)(i)(C). However, there is an exemption for balloon loans originated by small creditors that serve rural and underserved areas, as well as a temporary exemption for balloon loans originated by any small creditor. But even if your institution qualifies as a small creditor for purposes of the temporary balloon loan exemption (meaning that your institution has less than $2 billion in assets and sells no more than 2,000 first-lien covered mortgage loans per year), any such balloon loan must still have a loan term of five years or longer to qualify as a QM. 12 CFR 1026.43(f)(1)(iv)(C). Therefore, if you wish to make a balloon loan with a term that is shorter than five years, it will not qualify as a QM. (This conclusion is also expressed in the CFPB’s Small Creditor Qualified Mortgages Flowchart.)
Application of ATR Rules to Balloon Loans
While balloon loans with terms shorter than five years will not qualify as QMs, they may still pass muster under the overall ability-to-repay rules. However, for balloon loans with terms of five years or less, you will have to verify that your customer can make each loan payment, including the final balloon payment. For some customers, this may be possible, but we anticipate that this requirement would limit the pool of customers eligible to take out balloon loans with terms of five years or less.
The ATR rules require you to consider eight different factors in order to complete your “ability to repay” analysis. 12 CFR 1026.43(c)(1). Of those factors, the main hurdle for a balloon loan is the requirement to underwrite the consumer’s periodic payments. To satisfy that requirement, you would have to demonstrate that the consumer has the ability to pay the full balloon payment at the loan consummation.
However, if a balloon loan is not a higher-priced loan, you are required to consider only the “maximum payment scheduled during the first five years” of the loan. 12 CFR 1026.43(c)(5)(ii)(A)(1). In other words, you will not have to consider a balloon payment in making an ability-to-repay determination if the loan term is longer than five years and is not a higher-priced loan. But if the loan term is five years or shorter, you will have to consider the balloon payment in making an ability-to-repay determination (regardless of whether the loan is higher-priced or not). For examples of determining the ability to repay for balloon loan payments, see Official Interpretations, 12 CFR 1026.43, Paragraph 43(c)(5)(ii)(A), Comment 4.
When making a determination of a consumer’s ability to repay a balloon payment, the rules permit you to consider all sources of the consumer’s income and assets, including property other than the real property that secures the loan. 12 CFR 1026.43(c)(2)(i). The staff commentary includes several examples of other types of income and property that can be considered, such as “rental income, royalty payments . . . amounts vested in a retirement account, stocks, bonds, certificates of deposit, and amounts available to the consumer from a trust fund.” Official Interpretations, 12 CFR 1026.43, Paragraph 43(c)(2)(i), Comment 1.
Renewals of Existing Balloon Loans
We note that the ATR rules will not apply to renewals of existing loans, provided that they are not considered “refinancings” under Regulation Z. Official Interpretations, 12 CFR 1026, Paragraph 43(a), Comment 1 (“§ 1026.43 does not apply to any change to an existing loan that is not treated as a refinancing under § 1026.20(a)”). While we can provide you with some guidance on determining whether a renewal will be considered a refinancing, the issue is very fact-specific, and we cannot advise as to whether a specific balloon loan modification would be considered a refinancing (subjecting the transaction to Regulation Z and the new ability-to-repay (ATR) requirements).
The general rule is that a refinancing occurs only when an existing obligation is “satisfied and replaced by a new obligation undertaken by the same consumer.” 12 CFR 1026.20(a). The Regulation Z staff commentary states that this determination is “based on the parties’ contract and applicable law.” Official Interpretations, 12 CFR 1026, Paragraph 20(a), Comment 1. In addition, there is a specific exemption for any “renewal of a single payment obligation with no change in the original terms.” 12 CFR 1026.20(a)(1). This exception may apply to certain balloon loans, as it applies “both to obligations with a single payment of principal and interest and to obligations with periodic payments of interest and a final payment of principal.” Official Interpretations, 12 CFR 1026, Paragraph 20(a)(1), Comment 1.
While this issue apparently is not frequently litigated in court, we have found a few cases in which a court has determined a second transaction to be a modification and not a refinancing. It may be useful to examine the contract language relied on by those courts for their findings that the transactions at issue were modifications and not refinancings. See Rodriguez v. Chase Home Finance, LLC, No. 10 C 05876 (N.D. Ill. Sept. 23, 2011); In re Sheppard, 299 BR 753, 764 (Bankr. E.D.Penn. 2003).
For example, in the Illinois Rodriguez case, the modification agreement stated that it would “amend and supplement” the original note and mortgage. The modification also had an express disclaimer stating that “nothing in this Agreement shall be understood or construed to be a satisfaction or release in whole or in part of the obligations contained in the Loan Documents.” Based on those provisions in the modification agreement, the court found that the transaction was not a refinance.
Similar language in the Pennsylvania In re Sheppard case led the court to the same conclusion, that a loan modification was not a “refinance” for purposes of Regulation Z. In that case, the modification agreement stated that it “amends and supplements” the original security agreement, it required the borrower to “comply with all other covenants, agreements, and requirements” from the original security agreement, and it also stated that “[n]othing in this Agreement shall be understood or construed to be a satisfaction or release in whole or in part” of the original security agreement. Relying on those three provisions, the court held that the modification was not a refinance.
Also, the Seventh Circuit has considered renewals of single payment obligations to be exempt from the “refinance” definition, albeit in the context of a lump-sum payday loan. The court held that an extension of a loan beyond the original due date is not, automatically, a refinance. “To say, as plaintiffs do, that a loan ‘expires by its terms’ on the original due date is fanciful. All of the loan’s terms, including the repayment obligation, persist.” Jackson v. American Loan Co., Inc., 202 F.3d 911, 913 (7th Cir. 2000). Because the loan did not “expire” when it matured, the court held that it was possible to renew the loan without triggering Regulation Z’s refinance requirements.