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The Importance Of Compensating Factors On Manual Underwriting

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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 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.
  • Importance of compensating factors is crucial with borderline credit and challenged mortgage loan applications
  • 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 the following:
    • approve/eligible
    • referred/eligible
    • 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, lenders look for compensating factors
  • Cases where borrowers needs to realize the importance of compensating factors are when a mortgage borrower has the following:
    • low credit scores
    • limited credit history
    • open collections with 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

Layers of Risks On Borrowers

Depending on the amount of the layers of risk borrowers has, it must be offset by 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
  • Borrowers need to show strength
  • Show the underwriter a purpose to offset the level of risk
  • 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 an approval and a clear to close or getting a denial. 
  • There are a certain degree of risk factors with almost every mortgage loan

Factors That Shows Strength And Considered Compensating Factors

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 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 borrower has a debt to income ratio of 40% or lower, that would constitute a compensating factor
  • Substantial credit tradelines that has been aged
  • No late payment history aged
  • 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 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 borrowers has, the stronger the mortgage file
  • Lenders view the ability for borrowers 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 $2,000 per month, this is 0% 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
  • Provides strength 
  • The larger down payment also poses less risk for 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 borrowers 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 borrowers has been paying with cash, that cannot be used as proof of housing payment even though they get rental cash receipts from 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 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. Lenders view consistent pay increases as a strong sign of future job stability
  6. Also, if borrowers had a history of job promotions, this too is viewed very favorably
  7. Borrowers with 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. 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, this will be considered good likelihood of financial security
  9. For example, borrowers with part time job or 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.

  • Borrowers without 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
  • 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 history of declining income
  • This 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 lenders because it does not show stability
  • No verification of rent.

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