What Are Compensating Factors And Why Is It Important?

This BLOG On What Are Compensating Factors Was Written By Gustan Cho NMLS 873293

Many borrowers often ask the question What Are Compensating Factors? Mortgage Lenders are not required to originate and fund mortgage loans. Just because there are home loans that are insured by the government such as FHA Loans, VA Loans, and USDA Loans, it is not a requirement for the mortgage lender to follow the minimum government lending guidelines and can set their own lending standards that is above and beyond of those of FHA, VA, and USDA. These additional mortgage lending guidelines are called lender overlays. Mortgage lenders will not fund a loan to a borrower where they feel that the borrower is a risky candidate and may have a high probability of defaulting on their home loan. Even though a mortgage may be insured by FHA, no lender wants to go through a borrower defaulting on their mortgage loan and having FHA insure it because FHA monitors every single defaulted FHA Loan and if a FHA mortgage lender has a high default rate, they can be cut off HUD. What Are Compensating Factors? Compensating Factors are positive factors that a borrower has that will strengthen the borrower’s credit profile. Mortgage Underwriters look for strong compensating factors on borrowers who have a higher layer of risk such as the following:

  • Low credit scores
  • No established credit
  • Borrowers who live with family and have no verification of rent
  • Those who have large amounts of outstanding collection accounts
  • Buyers with higher debt to income ratios
  • Folks with gaps of employment and short term on the job or industry
  • Home buyers who do not have their own funds for the down payment and closing costs and are depending for gift funds
  • Consumers with other credit or financial issues that poses a higher risk level

Compensating Factors On FHA Loans

FHA Loans is by far the most popular mortgage loan program in the United States today. Borrowers with bruised credit, prior bankruptcies, foreclosures, deed in lieu, short sale, outstanding collection accounts, charge off accounts, higher debt to income ratios, recent late payments, and no or little credit tradelines can often qualify for FHA Loans but depending on their credit profile, compensating factors may be required for them to get a FHA Loan approval. FHA lenient mortgage lending guidelines makes it possible for many hard working Americans to qualify for a FHA Loan but yet, mortgage lenders are very careful on who they lend to because the last thing they want is for the borrower to default on their FHA Loan and go into foreclosure. Below are the FHA Guidelines to qualify for a FHA Loan:

  • Minimum credit scores to qualify for 3.5% down payment FHA Loan is 580 FICO
  • FHA does not require borrowers to pay off outstanding unpaid collection accounts or charge off accounts
  • FHA doesn’t require you to pay off judgments and/or tax liens to qualify for FHA Loan if you have written payment agreement and 3 months of payment history and can provide three months of canceled checks
  • FHA permits to get 100% gifted funds by a family member to be used for your down payment and closing costs
  • FHA allows borrowers to have multiple non-occupant co-borrowers. Non-occupant co-borrowers needs to be related to borrower by blood, law, or marriage
  • FHA allows debt to income ratios to be capped at 56.9% DTI for borrowers who have greater than 620 FICO Credit Scores
  • Borrowers with credit scores can have a maximum debt to income ratio not greater than 43% DTI
  • FHA borrowers who are into a Chapter 13 Bankruptcy Repayment Plan can  qualify for a FHA Loan one year into the Chapter 13 Bankruptcy Repayment Plan with the approval of the Chapter 13 Bankruptcy Trustee and proof of 12 months timely payments.
  • This is a manual underwriting and all manual underwrites require verification of rent
  • FHA has no waiting period after a Chapter 13 Bankruptcy Discharged Date to qualify for a FHA Loan

If you have several of the above conditions, compensating factors will help. What are compensating factors again? Compensating factors are factors that help borrowers offset the negatives on their credit and financial profiles.

Examples Of Compensating Factors

What Are Compensating Factors?

There are five solid compensating factors that mortgage lenders like to see with a high risk FHA mortgage loan application. Compensating factors will offset risks levels a FHA loan applicant has and will help the mortgage underwriter approve the file when it can be a potential denial. Below are compensating factors that lenders will take into consideration:

  1. Verified And Sourced Reserve Funds: Reserve Funds that are no gifted funds that is above and beyond funds needed to close. Reserves funds that are verified funds that is equal or greater than three month’s of the proposed P.I.T.I. ( Principal, Interest, Taxes, Interest) of the subject property ( if the subject property is one or two unit dwelling) is considered a strong compensating factor for the borrower. Verified and documented reserve funds that is equal to 6 months of P.I.T.I. on three to four unit subject purchase properties is considered a strong compensating factors.
  2. Payment Shock And Verification Of Rent : Mortgage lenders are often concerned with Payment Shock. What Payment Shock is when you go from how much you are currently payment for rent to what you will be paying on your mortgage payment or the least increase you have from paying rent to paying your new mortgage payment, the better. What is compensating factors on payment shock? A great compensating factor when it comes to payment shock is if you new P.I.T.I.  does not exceed 5% or $100.00, whichever amount is the lesser. This is proven and documented by providing 12 months canceled checks that is paid to the landlord. Timely 12 months payments are only considered compensating factors and not late payments. On a purchase transaction, many lenders will allow one 30 day late rental payments in the past 12 months.
  3. Borrowers Do Not Have Discretionary Debt: Another compensating factor is when there are no other debts other than the proposed housing debt. For example, credit card debts being paid off in full monthly and no installment loans or other loans. Credit tradelines are compensating factors as well but needs to be paid off in full in the past six months.
  4. Significant Additional Other Income : Additional other income such as overtime income, bonus income, part time income, or seasonal employment income that is not used for income qualification purposes on the mortgage loan application and that have been seasoned for at least one year and is likely to continue is considered as compensating factor.
  5. Residual Income Is Considered Compensating Factor: The mortgage borrower needs to have residual income which includes all members of the household of the occupying Mortgage Borrower without regard to the nature of their relationship. An individual may be omitted from the “family size” if they are fully supported from a source of verified income which is not included in the effective income (must be documented).

If you have further questions on compensating factors, please contact Gustan Cho at 262-716-8151 or email us at gcho@gustancho.com .

2017 UPDATE

This BLOG Was updated on March 7, 2017 by Gustan Cho NMLS 873293

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.

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