Importance Of Compensating Factors

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.

  • Importance Of Compensating Factors need 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 bad credit, high debt to income ratios, limited credit history, or needs to be manually underwritten added strength when a mortgage loan underwriter evaluates the applicant’s mortgage application.
  • Importance of compensating factors is crucial with borderline credit and challenged mortgage loan applications and it will be the determinant on whether the mortgage loan application gets approved or not.

Importance Of Compensating Factors On Manual Underwriting

For those mortgage applicants who cannot get an 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 an approve/eligible, referred/eligible, or referred with caution. 
  • A referred with caution means that the mortgage loan applicant does not qualify. 
  • A referred/eligible means that the mortgage loan applicant is qualified but cannot get an automated approval but is eligible for a manual underwrite.
  • 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, mortgage lenders look for importance of compensating factors. 
  • Cases where a mortgage loan applicant needs to realize the importance of compensating factors are when a mortgage borrower has low credit scores, limited credit history, open collections with balances, not enough credit tradelines, higher debt to income ratios.
  • Very little assets and where they are 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, and declining income are not positives and shows that the borrower’s file is weak.

Layers of Risks On Borrowers

Depending on the amount of the layers of risk a mortgage loan borrower has, it must be offset by substantial strengths of the borrower.

  • The more the risk factor, the more strenght and positive factors will be needed. 
  • Borrowers need to prove that they can make their mortgage payments
  • Borrowers need to show strength and show the underwriter a purpose to offset the level of risk the mortgage loan application is. 
  • Importance Of Compensating Factors is to show strengths on a mortgage loan application offsetting any risk factors which help to demonstrate the borrower’s probability and willingness and ability to repay the  mortgage loan. 
  • Providing compensating factors can be the difference between getting a mortgage loan approval and a clear to close and having a mortgage loan application getting a denial. 
  • There are a certain degree of risk factors with almost every mortgage loan.

Factors That Shows Strength

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 FICO are considered good credit and if the mortgage loan 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 mortgage loan applicant has a debt to income ratio of 40% or lower, than that would constitute a compensating factor for lower Debt to Income Ratios.
  • Substantial credit tradelines that has been aged with no late payment history aged and diversified types of credit are considered very strong factors.
  • What’s viewed as strong factors 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.
  • 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 your credit scores.
  • Liquid reserves of at least three to six months of housing payments, PITI (principal, interest, taxes, and insurance) is considered an extremely strong points.
  • The more reserves and assets a mortgage loan applicant has, the stronger the mortgage file.
  • Mortgage lenders view the ability for the mortgage loan applicant to save as a strong assets.
  • The mortgage applicant’s saving patterns and saving history carries 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 borrower.
  • 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 $2,500 per month, this is 25% payment shock and is considered a positive.
  • Home buyers who have large down payment than the minimum down payment required is considered a good factors and provides strength for the mortgage loan borrower.
  • The larger down payment also poses less risk for the mortgage lender as well.
  • Rental verification shows history of borrower being able to make timely housing payments.
  • Housing payment history and proof of payment via 12 months canceled checks shows housing responsibility.
  • VOR can only be used if the mortgage loan applicant has 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 the mortgage loan applicant has been paying with cash, that cannot be used as proof of housing payment even though they get rental cash receipts from the landlord.

Examples Of Compensating Factors

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

  1. Gift funds show weakness for the mortgage loan applicant because the home buyer is relying the down payment from a family member or relative and does not have their own skin in the game.
  2. Own sourced funds for the down payment and closing costs versus gift funds is considered compensating factor.
  3. Employment history – A long employment history shows job stability and the likelihood for future employment
  4. Longevity on the current job carries a lot of weight versus multiple jobs and gaps in employment in the past two year.
  5. Mortgage lenders view consistent pay increases as a strong sign of future job stability.
  6. Also, if the mortgage loan applicant has had a history of job promotions, this too is viewed very favorably.
  7. If the mortgage loan applicant has a history of going to school throughout the year to better himself and/or herself, this is considered another positive sign of future job stability.
  8. If a mortgage loan applicant has 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, this will be considered good likelihood of financial security.
  9. For example, for a mortgage loan applicant who has held a part time job or has overtime income for the past 18 months, but the income cannot be used because the minimum required for part time job and/or overtime income is at least a 24 month history.
  10. 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 adds to the risk layers of the mortgage loan applicant.

  • Mortgage loan applicants who do not have their own funds for the down payment and closing costs and no assets.
  • Minimal down payment and 100% gift funds for down payment and closing costs are considered risk layers for the mortgage lender.
  • 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 mortgage lenders will automatically deny a mortgage loan applicant that shows a history of declining income because it shows instability and potential that the income will continue to decline 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 mortgage lenders because it does not show stability.
  • No verification of rent.

2017 UPDATE On Importance Of Compensating Factors

This BLOG was updated on March 7, 2017 by Gustan Cho NMLS 873293 of The Gustan Cho Team at CrossCountry Mortgage.

The information contained on Gustan Cho Associates website is for informational purposes only and is not an advertisement for products offered by The Gustan Cho Team @ Gustan Cho Associates or its affiliates. The views and opinions expressed herein are those of the author and/or guest writers of Gustan Cho Associates Mortgage & Real Estate Information Resource Center website and do not reflect the policy of Gustan Cho Associates Lenders Network, its officers, subsidiaries, parent, or affiliates.

Comments are closed.