income and 36 percent for total debt obligations to gross income.<sup>52</sup> For subprime lending, the mortgage payment to income ratio was allowed to range much higher, averaging 41 percent in 2006, and in some cases exceeding 50 percent (Fitch, 2007).

**To evaluate the debt to income ratio adjustable rate mortgages (ARMs), the lender should estimate the affordability at a fully-adjusted rate of interest** . This requires assessing at the time of origination the borrower’s ability to pay at the fully indexed rate, ignoring any artificial discounts and taking into account predictable near term adjustments. In originating 2/28 and 3/27 ARMs, debt-to-income analysis was generally done only with the teaser rate, and no evaluation of the affordability of the fully adjusted rate was conducted.<sup>53</sup> In many cases, there was an expectation at the time the loan was made that the borrower would refinance to another, better loan before the adjustment point was reached. ARMs with periodic and lifetime caps on rate adjustment can be a useful product for lower and moderate income borrowers when correctly underwritten.

**Allow flexibility in sound credit management practices while increasing access for low and moderate income borrowers.** Lenders should be required to document borrower income, but be allowed flexibility with respect to the means by which informal income earners establish their ability to pay. This can include structured savings programs, rent and utility receipts, and co-signatures by friends and family members. Mexican lenders have developed proprietary credit scoring systems. Half of the mortgage lending in recent years funded by Mexico’s Federal Mortgage Company (known by its Spanish language acronym SHF) via non-bank lenders has reached households earning between the median and 70<sup>th</sup> percentile, a significant improvement over previous years, when most lending was to households in the 70<sup>th</sup> percentile or higher. As much as 15 percent of non-bank lending has gone to informal sector workers. SHF also supports microfinance for housing and subsidy programs for households earning less than the median.<sup>54</sup> Financial products such as mortgage default insurance have contributed to the stable extension of mortgage credit to moderate income households in Mexico, Hong Kong, the U.S., Canada, and other countries.

# **Prepayment fees should be limited to the actual financial cost of refinancing**

**incurred by the lender or investor.** Yield maintenance fees are common in many countries that feature long term fixed rate loans.<sup>55</sup> These fees eliminate the financial gain for the consumer from exercising the prepayment option. In some countries contractual limits on prepayment are the norm. Any such fees or limitations should be clearly disclosed to the borrower. Prepayment fees should not exceed the mark-to-market loss that the lender incurs as a result of prepayment.

> 52 Monthly housing payment includes principal, interest, taxes, and insurance. Total monthly obligations are defined as monthly housing payment plus other recurring debt obligations.

> 53 See comments by consumer advocates and lenders to the 2006 Interagency Guidance on Nontraditional lending at <u>www.occ.gov</u> or <u>www.federalreserve.gov</u> **<u>.</u>**

> 54 Sources: SHF, interviews with lenders.

> 55 For example: Germany, Ireland, Netherlands, Sweden. and Australia.

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