Underwriting to “Shadow Rent” in Compliance with Ability-to-Repay/QM Rules?

Article By: Ben Giumarra, Spillane Consulting Associates, Inc.

Getting some attention because of Fannie Mae’s HomeReady and other innovative programs, this an interesting question to review.

“Shadow rent” is non-borrower household income that can be contributed to the monthly housing payments. Earning $60,000 per year, single mom Bristol has a monthly mortgage payment of $2,000, recurring debts of $400, and thus a debt-to-income ratio of 48%. Not good. But what if her elderly father lives in a spare bedroom and makes the mortgage payment every third month. All of a sudden her debt-to-income ratio looks much more manageable at 35%.

It’s clear that there are dozens of factors we haven’t even considered yet. Does he plan to stay with her forever? Can he afford to keep making these payments?

But it’s also clear that completely ignoring such “shadow rent” would negatively impact many potential mortgage borrowers – perhaps predominantly low-to-moderate income or minority groups. Consider this quote from “Mortgage Lending and Non-Borrower Household Income”, a 2015 Working Paper by Fannie Mae’s Senior Economist Walter Scott:

Lower ownership rates among minority groups are of particular concern because of the demonstrated links between these rates and disparities in wealth. … However, minority families, along with those of lower incomes, may have difficulty transitioning from the rental market to homeownership in the current environment. … The tightening credit box [after the 2008 crisis] has disproportionally affected African-American and Hispanic borrowers, whose share of the purchase mortgage market fell from 20% to 12% between 2006 and 2013. 

And FAQs for Fannie Mae’s HomeReady product, which allows for “non-borrower household income flexibility” as a compensating factor, reports that “extended-household living arrangements are more common among underserved populations, including low-to-moderate-income, minority, and immigrant households.” In fact, the percentage of households deemed “Extended-Income Households” are higher than you might think:

  • 25% of Hispanic households
  • 20% of African American households
  • 20% of Asian households

At least that’s my opinion as a compliance guy – I’m sure some of the underwriters at my office will be waiting to stuff me in a locker when I get in to work today. Anyways – smart decision or no – this is how you can (if you want to) use “shadow rent” in compliance with ability-to-repay and qualified mortgage guidelines

General Ability-to-Repay/QM

Ever since 2014, we can’t originate a mortgage without (a) verifying any income/assets relied upon, (b) verifying all debt obligations, and (c) calculating a debt-to-income ratio using only verified items. Calculating DTI using verified items is required no matter which route you take, whether it be non-QM or any version of QM.

Under ATR/QM, we can consider only verifiable current or reasonably expected income, such as from wages, retirement benefits, alimony, or rental income.

Here are two different approaches to utilizing shadow rent in compliance with these standards:

Option #1 – Use as Qualifying Income

In using “shadow rent,” one option is to use this directly as qualifying income, similar to rental income- in other words, we’re looking at this as the borrower’s income (i.e. as the rent contributions, not the person’s total income). This is the less likely of two scenarios, and it’s harder to meet these requirements.

We need to verify this income with reasonably reliable third party records, including that it will reasonably continue for the foreseeable future. How can that be done? It’s a pretty high bar.

In a perfect world, we’d have a written rental agreement – where one person agrees to pay rent to the borrower. How likely is that to exist? And does this even count as “third party” record? Well, if it is signed by both the borrower and the non-borrower, it probably does. But boy it’s getting close. Might be even better if it were notarized. But that’s only half the battle – it still has to be “reasonably reliable” and show that this income source will continue. Now, if this was supported by bank records showing deposits into the borrower’s account in the amount shown in the contract, this starts to sound better. You would also want something to show this income is likely to consider, such as by a Letter of Intent (unless this is addressed in the rental agreement).

Here it’s going to be tough to meet secondary or appendix Q standards, so it’s likely you’ll be putting this on the books as a non-QM or a Small Creditor QM. But that’s troubling … consider 2 questions:

(1) If this is non-QM, are you comfortable with this being tested in court without any QM protection? (Civil Lawyer to Bank Witness: And tell us again why you think it was “reasonable” and in “good faith” for the Bank to consider a non-borrower’s income towards the loan underwriting …”) Yikes.

(2) If this is Small Creditor QM, you’re crazy to try and use this as qualifying income. You have no numerical limit to the DTI – so you only open yourself up to risk when you try to over-include income (or under-include debt), just underwrite it to worst-case-scenario and don’t leave any room for criticism.

Example – So using the example above, Bristol’s DTI would be reduced to 35%, but meeting the documentation requirements here would be very tough since a formal agreement with her father seems unlikely.

Option #2 – Treat as a Compensating Factor

Another option is to treat shadow rent as a compensating factor. I believe this is how Fannie Mae’s HomeReady product does it. You’re going to underwrite this by looking directly at the non-borrower’s income (not just the amount they’re contributing to the household). 

In this (more likely) scenario, there’s no formal agreement for the non-borrower to make any contributions towards the household. The idea, however, is that they’re there if necessary.

Importantly, you are not using this extra income as qualifying income. Moreover, you’re not even considering this as income going towards the ability-to-repay determination.  ATR/QM requires a good faith that the consumer (not other people living in the house) can afford the mortgage payment, and it requires that we verify the consumer’s income and debts, etc.etc. The non-borrower co-occupant supposedly paying shadow rent is not a “consumer” for these purposes. Instead, you’re legitimately using this as a compensating factor that is unrelated to ability-to-repay rule … “Yes, not including shadow rent, this consumer can afford this loan. But as compensating factors there is a low LTV and shadow rent, so if something bad does happen, we can either foreclose or the non-borrower co-occupants could help pay the rent.”

Compare this to how you’d underwrite a surety or guarantor. And note how the ATR/QM Rule does not require that we verify the credit history or debt obligations of the surety or guarantor (TILA commentary 1026.43(c)(2)(vi)-2 and 43(c)(2)(viii)-2.).

Now obviously even here you’ll need to verify this. A good idea is to require a letter of intent from the non-borrower that they plan to continue to live in the home for the next 12 months, as is required for the HomeReady product. We’ll need to verify the non-borrower’s income in the traditional ways – such as paystub or W-2.

Example – So in the example with Bristol and her Father, her DTI is going to stay the same at 48%. But the possibility of her Father helping out if times get tough (in other words, if our ability-to-repay determination was wrong) may be a compensating factor that justifies an exception to your normal DTI limitations.

On My Mind …

You’ve heard where studies shows willpower as a key factor to success – even more so than other attributes, such as general intelligence. You know, like the one where researchers asked 4-year-old kids not to eat a marshmallow?

So by all accounts Martin Luther King was an amazing person. Once-in-a-lifetime combination of intelligence, charisma, values, leadership, courage, and more. But what about his willpower? That’s what I was wondering when I remembered this story about him …

It’s January 30, 1956. MLK is giving a speech to a crowd in Montgomery, Alabama in support of the Rosa Parks bus boycott. Mid-speech, tragedy struck – he’s informed that his home has just been bombed, with his wife and infant daughter still inside. Rushing home, he finds a crater in the front yard and the front of his home destroyed, but his family safe from serious harm. By pure luck they had been in the back of the home when the explosion occurred.

Quickly, hundreds of angry protesters had gathered, many with weapons. The police (headed by a chief that had just recent declared his support publicly for the racist White Citizens Council) knew they were on the verge of losing control. The police chief came and begged MLK to talk them down – he knew the police force wasn’t equipped to handle a crowd of this size and fervor.

So what does MLK do next? He gets up and gives a speech. Not just any speech, but a speech so persuasive and so kind that the risk of a riot evaporates. The police credited it with saving their lives.

Don’t get panicky.  Don’t do anything panicky.  Don’t get your weapons. If you have weapons, take them home.  He who lives by the sword will perish by the sword.  Remember that is what Jesus said.  We are not advocating violence.  We want to love our enemies.  I want you to love our enemies.  Be good to them. This is what we must live by.  We must meet hate with love.

That to me is an exercise of other-wordly self-control. I imagine what I would’ve done in that same position, with my wife and daughter scared and bleeding, with essentially an army of supporters ready to provide an immediate and memorable message in response.

“Choose to be optimistic, it feels better.”  – Dalai Lama


Thank you to Ben Giumarra, Spillane Consulting Associates, Inc., a member of our Education Committee, who with the support of other experts at SCA have put together this newsletter.

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