What Are Compensating Factors And Importance On Manual Underwriting

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What Are Compensating Factors And Importance On Manual Underwriting

This BLOG On What Are Compensating Factors And Importance On Manual Underwriting Was UPDATED On November 5th, 2018

Many borrowers often ask the question What Are Compensating Factors?

  • 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, VA, and USDA Loans,
    • it is not a requirement for lenders to follow the minimum government lending guidelines
    • Lenders can have their own overlays
    • Lenders 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

Compensating Factors Required For Risky Borrowers

Lenders will not fund a loan where they feel is a risky candidate:

  • Low credit score borrowers 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
  • This is because HUD monitors every single defaulted FHA Loan
  • If lenders has a high default rate, they can be cut off HUD

How Compensating Factors Help Higher Risk Loans

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 Home Loans

FHA Loans is by far the most popular loan program in the United States today.

  • Borrowers with the following can qualify for FHA Home Loans:
    • bruised credit
    • prior bankruptcies
    • foreclosures
    • deed in lieu
    • short sale
    • outstanding collection accounts
    • charge off accounts
    • higher debt to income ratios
    • recent late payments
    • no or little credit tradelines can often qualify for FHA Loan

But depending on their credit profile, compensating factors may be required for them to get mortgage approval.

  • FHA lenient mortgage lending guidelines makes it possible for many hard working Americans to qualify for a FHA Loan
  • But yet, lenders are very careful on who they lend
  • This is because the last thing they want is for the borrower to default on their FHA Loan and go into foreclosure

HUD Guidelines On Home Purchase Loans

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
  • HUD does not require borrowers to pay off outstanding unpaid collection accounts or charge off accounts
  • HUD doesn’t require borrowers to pay off judgments and/or tax liens to qualify for FHA Loans if they have written payment agreement
    • need 3 months of payment history
    • need to provide three months of canceled checks
  • HUD permits to get 100% gifted funds by a family member to be used for down payment and closing costs
  • HUD allows borrowers to have multiple non-occupant co-borrowers
  • Non-occupant co-borrowers needs to be related to borrower by blood, law, or marriage
  • HUD 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
  • Borrowers who are into a Chapter 13 Bankruptcy Repayment Plan can qualify for VA and FHA Loans one year into the Chapter 13 Bankruptcy Repayment Plan
  • Need approval of the Chapter 13 Bankruptcy Trustee
  • Proof of 12 months timely payments
  • This is a manual underwriting
  • All manual underwrites require verification of rent
  • HUD has no waiting period after a Chapter 13 Bankruptcy Discharged Date

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 lenders like to see with a high risk mortgage loan applicants:

Compensating factors will offset risks levels loan applicants has. Will help mortgage underwriters approve the file when it can be a potential denial.

Below are compensating factors that lenders will take into consideration:

  • Verified And Sourced Reserve Funds:
    • Reserve Funds cannot be gifted funds
    • Reserves are 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
    • Reserves are required on multi-unit dwelling
    • Reserves 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
  • Payment Shock And Verification Of Rent :
    • Lenders are often concerned with Payment Shock
    • What Payment Shock is when renter go from how much they are currently payment for rent to what they will be paying on mortgage payment
    • Or the least increase they will have from paying rent to paying their 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
  • 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
  • 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
    • Have been seasoned for at least one year
    • Is likely to continue is considered as compensating factor
  • Residual Income Is Considered Compensating Factor:
    • Borrowers needs to have residual income
    • This includes all members of the household of the occupying 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 Associates at 262-716-8151 or text for faster response. Or email us at gcho@gustancho.com .

UPDATE On What Are Compensating Factors And Importance On Manual Underwriting

This BLOG On What Are Compensating Factors Was updated on November 5th, 2018 by Gustan Cho NMLS 873293

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