The Importance Of Compensating Factors On Manual Underwriting

This Article Is About Borrowers With Less Than Perfect Credit Need To Realize The Importance Of Compensating Factors

Borrowers with less than perfect credit need to realize the importance of compensating factors. The importance of compensating factors needs to be taken seriously because it can mean whether the borrower gets a loan approval or denial.

Strength and positive factors give the mortgage applicant who has the following:

  • bad credit
  • high debt to income ratios
  • limited credit history
  • Needs to be manually underwritten added strength when a mortgage underwriter evaluates the applicant’s mortgage application.
  • The importance of compensating factors is crucial with borderline credit and challenged mortgage loan applications
  • It will be the determinant of whether the mortgage loan application gets approved or not

In this article, we will discuss and cover The Importance Of Compensating Factors On Manual Underwriting.

Importance Of Compensating Factors On Manual Underwriting

Those mortgage applicants who cannot get automated approval by the Automated Underwriting System may qualify through manual underwriting. 

When a mortgage loan originator submits a mortgage loan application through the Automated Underwriting System, it will yield the following:

  • approve/eligible
  • referred/eligible
  • referred with caution

A referred with caution means that the mortgage loan applicant does not qualify. 

With manual underwrites and for those mortgage applicants who do get an approve/eligible with very marginal credit scores or high debt to income ratios, lenders look for compensating factors.

When Compensating Factors Benefit Manual Underwriting Borrowers

Cases, where borrowers need to realize the importance of compensating factors, are when a mortgage borrower has the following:

  • low credit scores
  • limited credit history
  • open collections with a balance
  • not enough credit tradelines
  • higher debt to income ratios
  • Very little assets
  • getting 100% gifted funds from family members for the down payment and/or closing costs
  • multiple jobs in the past two years
  • gaps in employment
  • declining income are not positives and shows that the borrower’s file is weak

Mortgage underwriters have a lot of power and underwriter discretion on manual underwrites.

Layered Risks Of Borrowers

Depending on the number of layers of risk borrowers have, it must be offset by the substantial strengths of the borrower. The more the risk factor, the more strength, and positive factors will be needed. Borrowers need to prove that they can make their mortgage payments and need to show strength. Show the underwriter a purpose to offset the level of risk. The importance Of Compensating Factors is to show strengths offsetting any risk factors which help to demonstrate the borrower’s probability and willingness and ability to repay the mortgage. Providing compensating factors can be the difference between getting approval and a clear to close or getting a denial. There is a certain degree of risk factors with almost every mortgage loan.

Factors That Shows Strength And Considered Compensating Factors

Mortgage underwriters have a lot of discretion on manual underwriting.

Residual income (average is $1,200 for a single person household and $2500 for a 2+ person household)

  • Long established credit history with high credit scores
  • Credit scores that are over 740 are considered a good credit
  • If mortgage applicant has maintained higher credit scores year after year, it is considered strengths
  • Lower DTI (Debt to Income Ratios) which is normally 5% or more under the mortgage program guidelines
  • For example, if the maximum debt to income ratio is at 45% and the borrower has a debt to income ratio of 40% or lower, that would constitute a compensating factor
  • Substantial credit tradelines that have been aged
  • No late payment history aged
  • Diversified types of credit are considered very strong factors

What’s viewed as strong factor with credit is having a combination of credit card payment history:

  • auto loan payment history
  • installment loan payment history
  • personal loan payment history
  • mortgage payment history

Mortgage underwriters have a lot of discretion on manual underwriting. Underwriters can exceed the recommended debt to income ratio on manual underwriting on borrowers with multiple strong compensating factors.

Different Types Of Seasoned Credit Tradelines Are Considered Strong Compensating Factors

Variety of credit tradelines instead of just one type of credit tradelines.

Having different types of credit accounts as opposed to just credit cards or just installment loans are viewed favorably and also maximize credit scores. Liquid reserves of at least three to six months of housing payments, PITI (principal, interest, taxes, and insurance) are considered extremely strong points. The more reserves and assets borrowers have, the stronger the mortgage file. Lenders view the ability for borrowers to save as strong assets. The mortgage applicant’s saving patterns and saving history carry strong weight on a mortgage loan applicant who has marginal credit high debt to income ratios, or other credit issues. Minimum payment shock, normally 30% or less shows strength for borrowers. For example, if the mortgage loan applicant has rental verification of $2,000 per month and his proposed new housing payment of principal, interest, taxes and insurance is $2,000 per month, this is 0% payment shock and is considered a positive. A payment shock of 5% or less is considered a strong compensating factor.

Importance Of Compensating Factors: Larger Down Payment Means Borrower Has Skin In The Game Thus Less Risk For The Lender

Homebuyers who have a large down payment than the minimum down payment required is considered a good factor.

Provides strength. The larger down payment also poses less risk for the lender as well. Rental verification shows the history of the borrower being able to make timely housing payments. Housing payment history and proof of payment via 12 months canceled checks show housing responsibility. VOR can only be used if borrowers have been paying his or her housing payments with checks for the past 12 months if the home they were renting was from a private landlord. If borrowers have been paying with cash, that cannot be used as proof of housing payment even though they get rental cash receipts from the landlord.

Importance Of Compensating Factors: Examples Of Compensating Factors

Importance Of Compensating Factors

FHA allows for a home buyer to get gift funds for their down payment and closing costs.

Gift funds show weakness for the applicant because the home buyer is relying on the down payment from a family member or relative and does not have their own skin in the game. Own sourced funds for the down payment and closing costs versus gift funds are considered compensating factors. Employment history – A long employment history shows job stability and the likelihood of future employment. Longevity on the current job carries a lot of weight versus multiple jobs and gaps in employment in the past two years. Lenders view consistent pay increases as a strong sign of future job stability. Also, if borrowers had a history of job promotions, this too is viewed very favorably. Borrowers with a history of going to school throughout the year to better themselves and/or themselves, this is considered another positive sign of future job stability. Borrowers with income that cannot be used but can be verified because of not having a two-year history and/or proof that the income will continue for the next three years, will be considered the good likelihood of financial security. For example, borrowers with a part-time job or overtime income for the past 18 months, but the income cannot be used because the minimum required for a part-time job and/or overtime income is at least a 24-month history.

This is verifiable income but cannot be used for income qualification,

Negative Factors Viewed By Mortgage Underwriters

The items below are generally not considered favorable and add to the risk layers of the mortgage loan applicant.

Borrowers without their own funds for the down payment and closing costs and no assets. Minimal down payment and 100% gift funds for the down payment and closing costs are considered risk layers. Poor credit history, open collections, numerous charge-offs, history of judgments, tax liens, lack of re-established credit, and recent late payments are considered risk factors. Declining income year after year. Some lenders will automatically deny borrowers with a history of declining income. This shows instability and the potential that the income will continue to decline for years to come.

Short credit history, not enough aged credit tradelines, and limited established credit. High debt to income ratios and excessive debt. Multiple jobs and gaps in employment in the past two years are considered risk factors for lenders because it does not show stability. No verification of rent! In general, mortgage underwriters want to see timely payments in the past 24 months on all manual underwrites. Again, one or two late payments in the past 24 months are not deal killers with strong compensating factors. Underwriters have a lot of underwriter discretion on manual underwrites. Mortgage underwriters can make exceptions on manual underwriting as long as borrowers have strong compensating factors. 

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