Mortgage Approvals and Compensating Factors

Mortgage loans are approved based on a fairly strict set of guidelines.  Some of the guidelines are hard rules that can not be broken.  An example of hard rule is the maximum loan to value ratios or down payment requirements.  If a home loan for a particular 30 year fixed rate mortgage requires a 5% down payment or a loan to value of 95%, 4.75% down payment will not be accepted.  On the other hand, some rules are general guidelines. 

An example of a general guideline is the debt ratio requirement.  Standard debt ratios are approximately 32% for the amount of the borrowers’ gross monthly income that can be used for the monthly mortgage payment and a 38% ratio representing the amount of the gross monthly income that can be allocated for the monthly mortgage payment and all other monthly debt obligations.  These debt ratios are guidelines.  A home loan applicant that has debt ratios of 33% and 40% may very well be approved for a mortgage loan. 

In situations where a home loan borrower has debt ratios that exceed the guidelines or perhaps a credit history that is slightly below the requirements, a mortgage lender will look for compensating factors to justify making the home loan approval.

Compensating factors that may be used to justify approval of mortgage loans with ratios exceeding the benchmark guidelines are evaluated on a case by case scenario.  Any compensating factor used to justify mortgage approval must be supported by documentation with the mortgage lender.

Common compensating factors that are reviewed to approve a home loan that is just marginally beneath the loan guidelines include:

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, one that is above the minimum established for the home loan program applied for, toward the purchase of the property.

The borrower has demonstrated an ability to accumulate savings and a conservative attitude toward the use of credit.

A 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 3 months worth) after closing.  In determining if an asset can be included as cash reserves or cash to close, the mortgage 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 home 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 ratio computations)

The borrower has potential for increased earnings, as indicated by job training or education in the borrower’s profession

The home is being purchased as the 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 mortgage loan underwriter must document the availability of such possible employment.