What Is Ability To Repay?

Ability To Repay Explained in Less Than 4 Minutes

Parents and two young children relaxing and laughing on couch
•••

MoMo Productions / Getty Images

Ability to repay is the capability of a borrower to pay back a mortgage. Banks must make reasonable and good-faith determinations to see if you qualify for a home loan. The phrase came into play after the mortgage crisis in 2010 with the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This act requires lenders to make—in good faith—an estimate of your ability to repay them for your home mortgage before they extend you credit.

Let’s take a look at ability to repay, how it works, and what it means for you.

Definition and Examples of Ability To Repay

Ability to repay is the capacity of a home loan borrower to make good on a mortgage. Mortgage lenders must make a good-faith estimate of a borrower’s qualification for a home loan. Prior to the mortgage crisis, many mortgage loans were created without regard to whether or not the borrower could repay them. This was precipitated by loose practices of banks, which failed to properly verify income and income. Banks were then allowed to offer adjustable-rate mortgages whose payments greatly increased after a few years, creating challenging repayment situations.

Ability to repay was introduced in 2010 with the Dodd-Frank Wall Street Reform and Consumer Protection Act. As a result of this act, banks are required to make a reasonable and good-faith determination that borrowers will be able to repay the money they’ve borrowed. This estimate comes as a result of thorough verification of documentation.

  • Acronym: ATR

The act requires that banks consider eight separate factors when determining your ability to repay:

  • Current or expected income or assets
  • Current employment status
  • Monthly mortgage payment for the home you’re trying to buy
  • Monthly payment amounts for any other loans
  • Monthly payment for any mortgage-related obligations
  • Current debts, child support, and alimony payments
  • Monthly debt-to-income ratio
  • Your credit history

These are minimum requirements; your bank may have stricter rules, so you’ll need to investigate that further.

How Ability To Repay Works

Let’s say you’re a single person living in a city. You already own a condo, but you’re looking for an investment property in a vacation town a couple of hours away. Before beginning your search, you get pre-approval from your bank for a mortgage loan. Once you’ve found the perfect property, you make an offer. The seller accepts and the two of you sign a sales agreement.

Once you’ve provided all your documentation to the bank, however, it comes to light that your debt-to-income ratio doesn’t quite meet the threshold that your lender requires. Due to this, your bank determines that your ability to repay is not viable, and thus it cannot give you a loan.

After consulting with your loan officer, you research the expected rent of other properties in the area. You find that the average rent for a home like yours is about $1,100 per month, and an appraiser that the bank sends out agrees with your assessment. Depending on your bank, you can use up to 75% of the market rent as qualifying income on your investment property.

This means that you can add $825 to your monthly income, thus increasing your expected income and dropping your debt-to-income ratio to an acceptable level.

Banks typically leave out the final 25% in income from an investment property to account for maintenance and vacancy.

What Does Ability To Repay Mean for You?

Buying a home can be an intensive, overwhelming process. Fortunately, the ability to repay decision is made by your bank, not you. To boost your chances of success when applying for a mortgage, you’ll want to make sure the eight criteria listed above are met.

This means you’ll need to possess substantial income, have stable work, consider all your monthly debt obligations, and maintain your credit score.

Key Takeaways

  • Ability to repay is the capacity for a borrower to pay back a mortgage. Banks must make reasonable and good-faith determinations to see if you qualify for a home loan.
  • The mortgage crisis in 2008 prompted the creation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which launched the phrase “ability to repay.”
  • Banks consider a minimum of eight factors when determining an individual’s ability to repay, including your credit history, outstanding debt obligations, employment status, and income.