Think you can qualify for a mortgage? Don't be so sure

The new mortgage underwriting rules of the Dodd-Frank Act have some unforeseen side effects.

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Effects of tight mortgage rules
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Effects of tight mortgage rules

Earlier this year, the Dodd-Frank Wall Street Reform and Consumer Protection Act mandated that mortgage lenders must follow many new guidelines when issuing mortgages. To enforce these new rules, the act created the Consumer Financial Protection Bureau (CFPB), aimed at protecting consumers from predatory or risky lending practices.

But with the new regulations and consumer protection come some side effects. Side effects that could affect many borrowers' ability to qualify for a mortgage, or get the type of mortgage they want.

Of the new regulations, the one that has gotten the most attention is the rule that states that a borrower's debt-to-income ratio cannot exceed 43 percent.

But, the new Dodd-Frank rules are changing the mortgage landscape beyond just that. Keep reading to learn about the less publicized effects of Dodd-Frank…

It's Harder for Self-Employed Borrowers and Freelancers to Get Approved

One of the most far-reaching effects of the Dodd-Frank Act is its strict requirement on lenders to provide, on demand, documentation to justify their mortgage approvals, says Jacob Gaffney, executive editor of HousingWire.com and HW Magazine, which covers the housing and mortgage industry.

One of groups this will affect the most is self-employed borrowers.

"Self-employed borrowers will need at least two years of consistent income and the tax returns to prove it," says Jim Duffy, a senior loan officer with Primary Residential Mortgage, Inc., a national independent mortgage banker.

He says there are a few ways this can affect people. For example, if their finances are inconsistent, it will be tougher to convince borrowers they are a good bet for a mortgage. And if they're used to writing a lot of expenses off, thereby resulting in a low profit (income), it could be tough to get a mortgage.

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One borrower, who preferred anonymity because he's a sound technician for various bands, recently discovered this the hard way. When he applied for a mortgage with his wife, they were told they wouldn't qualify because his income changed substantially over the previous year.

"I had made about $70,000 one year, then only around $30,000," he explains. He says he was expecting to make it up this year, which looked promising, but he still couldn't qualify. However, his accountant told him there was one way to possibly qualify.

"She told me I could claim and pay taxes on another $40,000, and then I might - might - qualify," he says. "In the end, I decided paying the government thousands of dollars in taxes on money I didn't even earn wasn't worth it."

It's Harder to Qualify for an ARM

Adjustable-Rate Mortgages (ARMs) are loans that start out with a low initial rate, and then adjust after a pre-determined period, typically anywhere from one to seven years. These, says Gaffney, were often used to qualify borrowers - the lower initial interest rate resulted in lower monthly payments, and therefore made it easier to qualify.

For instance, here's a look at the average interest rates for the week of February 06, 2014, according to Freddie Mac. The interest rate for a 30-year fixed-rate mortgage was 4.23 percent, while the interest rate for an ARM that adjusted after one year was 2.51 percent.

The resulting monthly payment on a $300,000 loan for each would be $1,472 vs. $1,187. It doesn't take a mortgage banker to realize that a lot more people will qualify for the ARM, which is $285 less per month - for the first year, anyway.

[Click to compare interest rates and loan options from lenders now.]

However, once that initial rate ends and the rate adjusts to the new, usually higher rate, it often spells trouble for those who barely qualified at the lower rate. This, says Gaffney, was one thing that led to many foreclosures, and something the Dodd-Frank Act is attempting to fix by requiring lenders to use the current market rate (in this case the 4.23 percent), as a qualifying benchmark.

The reality - and math - is a bit more complicated than that, but in general, Gaffney says it will result in much fewer people being able to qualify for ARMs.

Say Goodbye to Interest-Only Mortgages

Interest-only mortgages are ones in which you pay only the interest, and no principal, for a number of years, commonly five or seven, says Duffy. After that, you begin making payments that include both interest and principal, and therefore the payments are suddenly substantially higher.

These mortgages were popular among a select set of buyers, says Duffy. Specifically, executives and Wall Street types who work for a small salary and depend on huge end-of-year bonuses (when they can knock down a year's worth of mortgage principal in one massive payment); young borrowers who are certain they will make more money in a few years; or those who want to invest the principal money in other ways.

As such, the low initial mortgage payments can be very attractive.

When abused, however, they can get people into bad financial straits, says Duffy. This is because they sometimes allow people to qualify for homes they might not be able to afford when the interest-only term expires and their payment jumps up.

"So for many typical homeowners, [interest-only loans] can be risky," says Duffy.

In fact, Dodd-Frank rules categorize these mortgages as too risky. Gaffney says that while these loans may still be available with a small group of lenders, for all practical purposes, they're going the way of the dinosaurs.

Get Ready for More Paperwork

Remember the good old days of "no-doc" mortgages? If you don't, that meant mortgages approved with little or no documented proof of things like income, says Duffy. And even when you applied for a "full doc" mortgage, the requirement for documentation was often not as heavy as now, says Jonathan Corr, president of Ellie Mae, a mortgage origination software firm.

Unlike the past, when lenders more or less made their own standards surrounding documentation requirements, now they will answer to the previously mentioned Dodd-Frank-created watchdog, the Consumer Financial Protection Bureau (CFPB), says Corr.

"It's one thing to have to document and verify the loan, it's another thing to have to prove that you did it in the correct fashion [to the CFPB]," he says. That's the key difference, he says.

"Talk to people about how many things they ask you to put in place and document, back-up, verify, every I dotted and T crossed. It's a very different world than it was," adds Corr.

The Bottom Line

As Corr stated, the mortgage industry has changed quite a bit under the new Dodd-Frank rules. But, the good news is that for people who do have their paperwork in order and can actually afford the mortgage they want, the process should not only go smoothly, but borrowers should feel more financially secure, says Corr. And that's what the Dodd-Frank Act is all about in the long run.

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