What Are Compensating Factors?
By Gustan Cho
Compensating factors are positive factors that a mortgage loan applicant has which adds strength to the mortgage applicant in the view of the mortgage loan underwriter. Larger down payments, cash reserves, rental verification, low debt to income ratios, and job longevity are examples of compensating factors. Compensating factors are extremely important for mortgage loan applicants who have lower credit scores, a recent late payment, high debt to income ratios, 100% gifted funds and no funds of their own for the down payment, prior bankruptcy, foreclosure, deed in lieu of foreclosure, or short sale, and those mortgage applicants who cannot get an approve eligible per DU FINDINGS and need a manual underwrite.
Who Needs Compensating Factors?
A mortgage loan applicant who has a 580 FICO credit score, very little credit tradelines, no verification of rent, multiple job changes in the past 2 years, unpaid collection accounts, no reserves or down payment and needs the down payment to be gifted, and recent late payment history is a mortgage loan applicant who will need compensating factors.
What Is A Good Compensating Factor?
The layers of risk a mortgage lender is faced with needs to be offset by one or many compensating factors for a less than perfect mortgage loan borrower with weak credit and financial profile. Compensating factors are viewed as positive strength on a mortgage application that offsets the risk factors the mortgage lender faces and helps demonstrate the mortgage loan borrower’s willingness to pay and the mortgage loan applicant’s ability to pay the mortgage loan. All mortgage loans have a degree of risk factors and using the many risk factors a weak credit profile mortgage loan applicant faces and adding the compensating factors the applicant has can greatly increase the chances of the mortgage applicant chances of a mortgage loan approval.
Examples Of Positive Compensation Factors
High residual income is one of the best compensating factors for mortgage loan underwriters. A residual household residual income of $1,200 for a single person household and for a two plus person household, a $2,500 residual income is considered a favorable compensating factor.
Low debt to income ratios is considered a compensating factor. What is a lower debt to income ratio to be considered a positive compensating factor? A debt to income ratio that is lower than 5% or more than the mortgage loan programs maximum requirement is considered a positive compensating factor.
A higher credit score and positive credit history with longevity is considered a positve compensating factor in the views of a mortgage lender. Higher credit scores are FICO credit scores that are 720 FICO or higher. Various types of credit tradelines with longevity is considered positive and good compensating factors.
Reserves, cash in bank, is a strong compensating factor. 3 to 6 months of reserves which include principal, interest, taxes, and homeowners insurance are considered reserves. A history of saving pattern is a very strong compensating factor. Investment accounts, CD’s, and mutual fund investment accounts prove financial responsibility and the eagerness of the mortgage loan borrower to save.
Rental verification is a strong compensating factor. Rental verification is only valid if the mortgage loan applicant can provide 12 months canceled checks that was made out to the landlord. For those renters who are renting from a registered property management company, a letter from the property manager is a valid rental verification. Low payment shock is a strong compensating factor. For example, if the renter is currently paying $1,000 in rent and the proposed new housing payment that includes principal, interest, taxes, and insurance is $1,250, this is a strong good compensating factor. Up to 25% or less payment shock is a strong compensating factor.
Larger down payment than the minimum required is considered a strong compensating factor. For example, if the minimum down payment required is 3.5% on a home purchase and the home buyer want to put 10% down payment, this is considered a strong compensating factor and less risk on the mortgage lender because the home buyer has more skin in the game.
FHA loan programs require a minimum of 3.5% down payment and 100% of the down payment can be gifted by a family member and/or relative of the mortgage loan borrower. If the mortgage loan borrower has his or her own funds for the down payment instead of getting 100% funds gifted for the down payment, it is considered a stronger borrower and adds more weight in the financial and credit strength of the borrower.
Employment history and a history of income increases is a strong compensating factor for the mortgage loan borrower. Also, verified income but income that cannot be used is considered a strong compensating factor. For example, to be able to use overtime or part time income, the mortgage loan borrower needs a 24 month history. If the mortgage loan borrower only has 18 months of overtime or part time income, it cannot be used as income since it is short of the 24 month requirement. However, the overtime and part time income can be verified so this verified income is a compensating factor even though it cannot be used for income qualification purposes.
Risk Factors Viewed By Mortgage Lenders
There are several factors that mortgage lenders view as risk factors. Mortgage lenders view limited reserves as high risk factors. Smaller down payments or minimum down payments are considered as risk factors versus larger down payments by home buyers. No rental verification and weak credit payment history are also considered risk factors by mortgage lenders. Limited credit and credit history are considered risk factors. High debt to income ratios are definitely risk factors.
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