In the wake of the housing crash, mortgage lenders didn’t need much reason to turn down loans. Back then, a single weakness could’ve stopped you from qualifying for a mortgage. Credit score too low? No loan for you. Debt ratio too high. Sorry, no dice.
But recent trends, statistics and anecdotal evidence suggest that mortgage lenders are once more considering the “whole borrower.” That is, they are looking at the bigger picture of borrower qualification, and giving more weight to compensating factors. This is good news for borrowers who have some kind of blemish on their credit profiles.
Signs of Easing Within the Lending Industry
Each month, mortgage software company Ellie Mae publishes an “Origination Insight Report” that reveals certain trends from across the lending industry. The report pulls data from more than 20% of all loan originations in the U.S. Their latest report for August 2013 showed continued easing of standards within the mortgage industry.
Last month, the average FICO credit score for loans that actually closed dropped to 734. That was the lowest average since the company began tracking this trend in 2011. But that wasn’t the only sign of easing. According to Jonathan Corr, CEO of Ellie Mae: “loan-to-value and debt-to-income ratios rose slightly again last month, continuing the credit-easing trend.”
We have received reports from lenders that suggest the same thing. Mortgage lenders appear to be putting more emphasis on the big picture these days, as opposed to individual qualification factors. As a result, borrowers who are weak in one area might still be approved for a mortgage, if they have compensating strengths in another area.
To quote a recent article by real estate columnist Kenneth Harney, these trends tell home buyers: “Just because you don’t have stellar [credit] scores, you can still be approved if your application shows compensating strengths.”
So let’s talk about those compensating factors.
Compensating Factors: A Path to Mortgage Approval
There are many examples of compensating factors in the world of mortgage approval. Here are three common scenarios where strengths in one area can overcome weaknesses in another:
1. Low credit score, but plenty of assets
Roger is applying for a 30-year mortgage loan to buy a house. His credit score is a few points lower than what the lender typically requires for approval. His score took a hit a few years back, when he maxed out some credit cards after losing his job. This counts against him.
But Roger has a new job and has since saved up plenty of money for his purchase. He can afford to make a down payment of 20% and would still have six months worth of payments in his savings account after closing. These are strong compensating factors. The lender approves Roger by considering the big picture.
2. Small down payment, but great credit and low debt
Anne is a responsible borrower. She has always repaid her debts on time and in full, and she takes pride in this. But pride isn’t the only takeaway. Anne has also earned herself a high credit score. Her FICO score is north of 800, which is considered excellent by mortgage lenders. She also has very little debt.
But she can only afford a down payment of 4%, as compared to the 5% minimum typically required on conventional mortgage loans. Her smaller down payment means the lender will be exposed to more risk. But her credit score paints the picture of a low-risk borrower.
She speaks to her local credit union, which offers a 3% down-payment option for well-qualified borrowers. The lender approves Anne as a result of compensating factors — high credit score and low debt-to-income ratio. It’s another “big picture” approval scenario.
3. High debt ratios, but two steady jobs
Mike and Sarah have accumulated some debt over the years. Between the two of them, their total debt-to-income (DTI) ratio is 39%. They apply for a mortgage loan with a lender that typically draws the line at 36% – 37%.
But Mike and Sarah are both gainfully employed and have been for many years. Mike recently completed some additional job training that makes him even more employable within his industry. Sarah recently got a promotion and pay raise. Both borrowers have decent credit scores. They can afford a down payment of 10%.
Despite having a DTI ratio slightly higher than preferred, the couple are approved for a loan. Their employment situation, credit scores, and down payment are compensating factors that outweigh the slightly elevated DTI ratio.
The Federal Housing Administration (FHA) also allows for compensating factors when it comes to debt ratios. Chapter 4 of HUD Handbook 4155.1 states that “the relationship of total obligations to income is considered acceptable if the total mortgage payment and all recurring monthly obligations do not exceed 43% of the gross effective income.”
But it goes on to explain that lenders can approve borrowers above this limit if they document compensating factors in other areas.
In the FHA scenario, a compensating factor would be if the borrower has shown the ability to manage payments equal to, or greater than, the payments on the new loan for at least two years. A down payment of 10% or larger (higher than FHA’s 3.5% minimum) would be another compensating factor in this scenario.
The message to prospective borrowers is this: Mortgage lenders may bend their rules in one area if you are well qualified in other areas. Compensating factors can make up for the occasional blemish. So don’t assume you are unqualified for a mortgage, just because of an article you read about credit scores or debt ratios. Consider the bigger picture. That’s what lenders do.