What are Compensating Factors When Qualifying for a Mortgage?

Although we wouldn’t know it from watching the six o’clock news, mortgage underwriting guidelines and mortgage insurance underwriting guidelines have been in a pattern of loosening, not tightening.  This trend started in late 2009 and continues today with such examples as lower minimum credit scores for mortgage underwriting guidelines and fewer declining markets for mortgage insurance guidelines.  As this has happened, another trend has emerged.  The phrase “underwriting exception” is coming back in practical contexts rather than a nostalgic reference to days gone by.  These days, underwriting exceptions are more and more common where a mortgage loan file has “Compensating Factors.”

At face value, the phrase compensating factor seems to have a common sense meaning (an element of a credit application that is so strong that it offsets something weaker in the application) but it’s more complicated than that.  Different mortgage types manage the consideration of compensating factors in different ways.  For instance, conventional loans backed by Fannie Mae and Freddie Mac typically evaluate them using an Automated Underwriting System (a software system that determines a borrower’s loan eligibility based on a predetermined set of financial criteria and is subsequently reviewed by a human).  FHA and VA mortgages are also evaluated this way but are underwritten manually too.  Through all these models, the principles of Compensating Factors remain the same.

FHA’s written guidelines outline specific examples of what compensating factors may be taken into consideration:

  • The borrower has successfully demonstrated the ability to pay housing expenses equal to or greater than the proposed monthly housing expense for the new mortgage over the past 12-24 months.
  • The borrower makes a large down payment (ten percent or more) toward the purchase of the property.
  • The borrower has demonstrated an ability to accumulate savings and a conservative attitude toward the use of credit.
  • Previous credit history shows that the borrower has the ability to devote a greater portion of income to housing expenses.
  • The borrower receives documented compensation or income not reflected in effective income, but directly affecting the ability to pay the mortgage, including food stamps and similar public benefits.
  • There is only a minimal increase in the borrower’s housing expense.
  • The borrower has substantial documented cash reserves (at least three months’ worth) after closing. In determining if an asset can be included as cash reserves or cash to close, the lender must judge whether or not the asset is liquid or readily convertible to cash and can be done so absent retirement or job termination.
  • Funds borrowed against these accounts may be used for loan closing, but are not to be considered as cash reserves. “Assets” such as equity in other properties and the proceeds from a cash-out refinance are not to be considered as cash reserves. Similarly, funds from gifts from any source are not to be included as cash reserves.
  • The borrower has substantial non-taxable income (if no adjustment was made previously in the debt to income ratio computations).
  • The borrower has a potential for increased earnings, as indicated by job training or education in the borrower’s profession.
  • The home is being purchased as a result of relocation of the primary wage-earner, and the secondary wage-earner has an established history of employment, is expected to return to work, and reasonable prospects exist for securing employment in a similar occupation in the new area. The underwriter must document the availability of such possible employment.

There are other examples not specifically mentioned here such as a monthly housing payment being low by comparison to the borrowers’ monthly income or a high debt to income ratio might be allowed if a house with a mortgage against it is pending sale but won’t close prior to the need for the new mortgage.   Any compensating factor used to justify mortgage approval must be supported by documentation to be considered.

With lending guidelines taking a more open mind, it’s time to look to compensating factors when a situation arises where a credit score is slightly low, a debt to income ratio is high, a buyer needs to temporarily assume 2 housing payments and a number of other circumstances.  Be sure not to buy into what you see on the evening news and trust that common sense in mortgage underwriting is more real than many might think.  Be in the know and take advantage of it!

Charles Dailey – Branch Manager, Loan Officer, Certified Military Housing Specialist – CA DOC, MN DOC & WI DFI

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