Believe it or not, subprime loans are still around – they just have a different name. Yes, the requirements are a little stricter than they were before, but not by a lot. They are not required to follow the same guidelines as conventional loans that must meet the Qualified Mortgage Guidelines, which means that your debt ratio must be lower than 43 percent and you must be able to prove your income the standard way, with paystubs and W-2s or tax returns. It also means that you cannot have any type of negative amortization on your loan and the lender cannot charge you more than 3 points on your loan. As we all know, subprime loans break most of those rules, but the good news is that they do not have to meet them. What they do have to meet, however, is the Ability to Repay Rule.
What is the Ability to Repay Rule?
The Ability to Repay Rule is a rule put in place to ensure that you can genuinely afford the loan. Any loan, whether conventional or subprime must meet these requirements. As the name suggests, the ability to repay, means that you can afford the loan, which must be proven in a variety of ways including:
- Verification of your income in the method the bank determines is acceptable
- The determination that your debt ratio is not excessively high
- Verification that your employment is stable
- Verification of your assets
What this rule does not say is how the lender needs to verify these things. For example, you are not required to provide paystubs and W-2s to verify your income – you may be able to provide bank statements if you are choosing an alternative documentation loan.
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The Lender’s Discretion
The key difference in alternative documentation loans is that the lender has a say in how things go. As long as the lender can prove in some way that they verified your income, employment, and credit history, your loan can pass the Ability to Repay Rule. Every lender can have different rules regarding how this is done. For example, some lenders might require paystubs and W-2s while another will accept bank statements alone and yet another might take bank statements but require at least one paystub to prove that you do work where you say you work. The guidelines really do not state what a lender has to do.
You can look at the Ability to Repay Rule as a way for lenders to have different overlays. Just as with a government backed loan, lenders can add their own requirements on a loan, the same is true for subprime or alternative documentation loans. The key factor is that the lender completed their due diligence thoroughly. Let’s look at an example:
- Joe applies for an alternative documentation loan because he works on commission – 50% of his income is from commission. He provides the lender with his bank statements to prove his income. The lender accepts the bank statements and gives him the loan, despite the fact that he had a 550 credit score and did not have any reserves on hand. This is a very risky loan which would not pass the Ability to Repay rule.
- Jane, on the other hand, also works on commission – her income is also made up of 50% commission. Her credit score, however, is much higher; it is 700. She also has 6 months’ worth of reserves on hand. Her loan does pass the Ability to Repay rule.
The lender simply needs to determine that you can, in fact, afford the loan. This can be done in any manner they prefer to use, as long as they can prove that they evaluated your loan for affordability.