We qualify as a small creditor under the Qualified Mortgage (QM) rules, but we are not located in a “rural or underserved area.” We do make portfolio balloon loans that qualify for the small creditor balloon QM exemption, but that expires on April 1st of this year. After that date, can we continue to make balloon mortgages? Do you recommend not offering balloon loans and instead offering adjustable rate mortgages?

We believe you may continue offering balloon loans that pass an ability-to-repay (ATR) analysis. However, your balloon loans will not qualify as QMs after April 1, 2016, unless you qualify for the “rural or underserved” exception to the QM requirements (which may be subject to change, as discussed below). As you suggested, an ARM loan may be a workable alternative, since ARMs are eligible for QM status.

Ability-to-Repay Analysis for Balloon Loans

The ATR rules require you to analyze eight factors when underwriting a covered residential mortgage loan. Of those factors, the primary hurdle for a balloon loan is the requirement to take into account all of the borrower’s periodic payments, including the final balloon payment, which would be much larger than the other periodic payments.

You are not required to take into account the final balloon payment if the loan term is longer than five years, provided that the loan is not a “higher-priced” mortgage loan. On the other hand, if the loan is “higher-priced” — meaning that the interest rate exceeds 1.5%, 2.5% or 3.5% over the average prime offer rate (depending on the lien position and loan amount) — you are required to take into account the balloon payment, regardless of the loan term.

Balloon Loans as Qualified Mortgages

Generally, a QM cannot have a balloon payment feature, even if the loan is held in portfolio. As you noted, there is an exemption to this rule for qualifying “small creditors” that will expire on April 1, 2016.

There is a permanent exemption for small creditors that “predominantly” serve rural and underserved areas (meaning that more than 50% of your closed-end, dwelling-secured first lien loans are made in counties that qualify as “rural” or “underserved,” as determined by the CFPB). But if your institution does not “predominantly” serve rural or underserved areas, you will not be able to originate QM loans with balloon payments (although this may change in the near future).

The recently enacted FAST Act amended the Truth in Lending Act (TILA) to strike the word “predominantly” from the TILA, as follows:

“The Bureau may, by regulation, provide that the term ‘qualified mortgage’ includes a balloon loan . . . (iv) that is extended by a creditor that (I) operates ~~predominantly~~ in rural or underserved areas . . . .”

Due to the permissive nature of this language (“the Bureau may, by regulation . . . .”), we would not rely on this change until the CFPB has implemented it in a final rulemaking. We have contacted the CFPB to inquire about their plans to implement this change and will provide an update as soon as the agency responds.

Adjustable-Rate Mortgages as Qualified Mortgages

An ARM may qualify as a QM, provided that it meets the other QM requirements. When underwriting the loan, you must take into account the adjustable periodic payments under special QM rules. For example, if a range of interest rates could apply in the first five years, you must take into account the highest possible interest rate in that range for purposes of your QM analysis. For more details on underwriting ARM payments under the QM rules, see the links to the Official Interpretations below.

For resources related to our guidance, please see:

Regulation Z, Ability-to-Repay Rules, 12 CFR 1026.43(c)(2) (Requirement to determine a borrower’s ability-to-repay, based on eight specified factors.)

Regulation Z, Ability-to-Repay Rules, 12 CFR 1026.43(c)(5)(ii)(A)(1) (A creditor’s ability-to-repay analysis must consider “(1) the maximum payment scheduled during the first five years after the date on which the first regular periodic payment will be due for a loan that is not a higher-priced covered transaction . . . .”)

Official Interpretations, 12 CFR 1026.43, Paragraph 43(c)(5)(ii)(A), Comment 4 (This comment provides examples of loans with a balloon payment that are not higher-priced.)

Regulation Z, Qualified Mortgage Rules, 12 CFR 1026.43(e)(2)(i)(C) (The payment schedule for a qualified mortgage cannot “result in a balloon payment . . . except as provided in paragraph (f) of this section.”)

Regulation Z, Qualified Mortgage Rules, 12 CFR 1026.43(f)12 CFR 1026.35(b)(2)(iii)(A) (Permanent balloon loan exemption for small creditors that “extended more than 50 percent of its total covered transactions . . . secured by a first lien, on properties that are located in counties that are either ‘rural’ or ‘underserved;’ . . .”)

Regulation Z, Qualified Mortgage Rules, 12 CFR 1026.43(e)(2)(i) (A qualified mortgage must have “regular periodic payments that are substantially equal, except for the effect that any interest rate change after consummation has on the payment in the case of an adjustable-rate or step-rate mortgage . . . .”)

Regulation Z, Qualified Mortgage Rules, 12 CFR 1026.43(e)(2)(iv) (A creditor must underwrite a qualified mortgage using “the maximum interest rate that may apply during the first five years after the date on which the first regular periodic payment will be due . . . .”)

Official Interpretations, Regulation Z, 12 CFR 1026, Paragraph 43(e)(2)(iv), Comments 1 – 5 (CFPB staff commentary on underwriting periodic payments for adjustable rate mortgages.)