How Regulation Z Calculates Ability to Repay for an Interest-Only Loan

Interest-only payments can make an early mortgage payment look affordable even though principal is not declining. Regulation Z therefore requires a creditor evaluating repayment ability to account for the payment after the loan recasts to require principal and interest.

Use the post-recast payment

For an interest-only loan, the creditor calculates the substantially equal monthly principal-and-interest payment that would repay the loan amount over the term remaining when the loan recasts. If the borrower paid no principal during the interest-only phase, the balance used is generally the outstanding principal at recast. The creditor should not qualify the borrower using only the introductory interest-only payment.

Use the required interest rate

The rule's payment calculation uses the fully indexed rate or the introductory rate, whichever is greater. For an adjustable-rate loan, the fully indexed rate is calculated from the index value and margin at consummation, subject to the specific ATR rule. This can produce a payment materially higher than the initial payment.

Illustration

The CFPB's rule gives an example of a $200,000, 30-year fixed-rate mortgage with interest-only payments for five years at 7%. The scheduled initial payment covers interest only. For ATR, the creditor considers a fully amortizing payment that repays $200,000 over the 25 years remaining after the recast. The example demonstrates why the interest-only amount is not the relevant long-term repayment test.

Do not confuse an interest-only loan with negative amortization

An interest-only payment covers accrued interest but does not reduce principal. A negative-amortization payment is less than the accrued interest, causing the unpaid interest to increase principal. Regulation Z defines these structures separately, and the applicable ATR calculation depends on the loan's terms.

Exam checklist

1. Identify whether scheduled payments may be interest-only.
2. Find the date the loan recasts and the remaining term at that time.
3. Use the greater of the fully indexed rate or introductory rate as required.
4. Calculate the substantially equal fully amortizing payment, not merely the initial interest-only amount.
5. Apply other ATR requirements and any applicable exceptions separately.

Key takeaway

For ATR, project the payment that will fully amortize the balance after recast. A low initial interest-only payment does not establish that the borrower can repay the loan.

Calculate after the interest-only phase

For a covered interest-only loan, the ATR payment calculation generally uses the substantially equal monthly principal-and-interest payment that would repay the loan over the remaining term when the interest-only period ends. Because principal did not decline during the interest-only period, the balance at recast may remain near the original principal. The low scheduled interest-only payment is not the qualifying payment.

Use the required rate assumption

For an adjustable-rate loan with an introductory rate, the rule generally uses the greater of the fully indexed rate at consummation or the introductory rate in the prescribed calculation. The fully indexed rate is index plus margin, subject to the regulatory method. Do not simply use the current teaser rate because it is the rate the borrower pays initially.

Worked example

A $200,000 fixed-rate mortgage has a 30-year term and a five-year interest-only period at 7%. The initial scheduled payment covers interest, but ATR evaluates a fully amortizing payment that repays the $200,000 over the 25 years remaining after recast. The monthly amount is therefore materially higher than interest-only. The CFPB regulation includes an example illustrating this approach.

Interest-only is not negative amortization

An interest-only payment covers accrued interest but does not reduce principal. In a negative-amortization structure, the payment can be less than accrued interest and the unpaid amount is added to principal. Regulation Z treats these features separately, though a product could include more than one. Read the legal obligation and apply the calculation for its actual terms.

Other ATR obligations remain

Using the correct payment does not complete the ability-to-repay analysis. The creditor must consider and verify required consumer financial information and make a reasonable, good-faith determination under §1026.43. An MLO should not state that a borrower qualifies solely because the post-recast payment was calculated.

Exam method

Identify the IO period, balance when it ends, remaining term, and required rate. Compute a fully amortizing principal-and-interest payment for the recast period, then distinguish the calculation from the broader ATR determination and from a negative-amortization feature.

Use the legal obligation, not a marketing illustration

The payment calculation follows the actual loan terms: interest-only duration, balance, remaining amortization period, and rate assumptions. If the loan has a variable rate, apply the regulatory fully indexed rate method and compare it with the introductory rate as required. Do not substitute a payment example from another product.

Separate payment calculation from documentation

The creditor must also document the information used in its ATR determination and verify required items. A mathematically correct post-recast payment is not enough if income, assets, debts, or other required information was not considered. MLOs should route missing verification to underwriting instead of asserting repayment ability.

Additional compliance detail

The applicable ATR rule has separate methods for balloon and negative-amortization products. If an interest-only loan also includes another feature, identify each feature and apply the specific paragraph rather than using a generic post-recast formula. Have underwriting or compliance resolve mixed-feature cases.