In 2008, the Federal Reserve adopted a new Truth in Lending Act and then updated the act in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act for short). These acts were adopted to set up a system of rules to make lenders more accountable and protect people from predatory lending practices.
Before these rules were created, lenders were handing out loans left and right without first determining whether people could really afford them. Often, unbeknownst to the borrower, the loans would have variable interest rates that started low and then escalated way beyond an affordable level. Lenders didn’t really care if people could afford the loans because they would make their money back right away by selling the loans to third parties.
This gave lenders an incentive to make as many loans as possible, despite the loans being rather risky and unstable. The number of these unstable loans kept growing, creating the housing bubble that eventually burst and plunged the United States into economic recession in 2008. Below are some of the changes put in place by the Dodd-Frank Act to help protect borrowers.
Now lenders are required to take a more in-depth look at borrowers’ financial situations to determine if they can truly afford the loans. This means lenders are now paying closer attention to how much debt a borrower has in relation to how much income he or she receives.
If a borrower already has a large amount of existing debt, lenders will require that the borrower pay off some of the debt first in order to be in a healthier financial situation prior to receiving financing. Lenders will also look more closely at borrowers’ expenses and what liquid assets the borrower has to fall back on in case of a drop in income.
Before the housing crisis, borrowers would receive hefty fees for trying to get out of subprime mortgages early by selling or refinancing their homes. This meant that even though the lenders convinced the borrowers to take out loans they couldn’t afford in the first place, the borrowers were the ones to suffer for it.
Now, lenders can only require prepayment penalties if the loan:
Basically, the rule allows prepayment penalties if all these conditions are met because only then will a prepayment penalty be fair to the borrower.
Now lenders won’t just take your word for how much money you bring in; they are required to receive proof of your income, such as:
By creating this transparency in the borrower’s finances, both the borrower and lender can better assess whether the borrower will be able to repay.
While the new rules set up by the Dodd-Frank Act may make it harder for a few borrowers to obtain approval for a loan, these rules are vital for helping ensure that the borrowers can actually afford the loans in the first place.
This ultimately helps borrowers from being kicked out of their homes by foreclosure later on down the road and also helps to make sure that the country doesn’t suffer another dramatic decline in the housing market like it did in the late 2000s. So in the vast majority of cases, the heightened regulations end up helping both the borrower and lender more than they hurt them. A little extra work on the front end seems to be worth stopping the disaster that could happen otherwise.