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.
Qualifying for a Mortgage for the Self-Employed
Many potential home loan borrowers that are self employed believe that it is much more difficult to be approved for a new mortgage if you are self employed. While it can certainly be difficult for a self-employed buyer to qualify for a mortgage, the qualifying standards for a self employed borrower and the qualification standards for a wage earner or salaried borrower are the same.
The difficulty with the approval process is not with different underwriting standards it is simply that self employed borrowers often have irregular income and unsubstantiated savings or reserves.
It is often difficult for the self-employed individual to predict cash flow and business profits on a regular basis, making a self employed borrowers income highly variable. It is that variable income that presents the biggest obstacle.
Complicating the matter even further, in the past, mortgage lenders made a whole host of mortgage to self employed borrowers that were low and no documentation loans. A large portion of these home loans have since gone into default, casting self-employed home buyers in a negative light and making mortgage lenders hesitant top offer any home loan products with additional layers of risk available to self employed borrowers.
Self-employed borrowers must demonstrate an appropriate net income before they can obtain a home loan. This guideline is no different than it is for a wage earner applying for a home loan. Standard mortgage guidelines call for verification of a two year average of monthly income.
This is true whether the borrower is self employed or not. Sometimes automated underwriting systems will require only a one year verification of income, this may be found in some case where borrowers have very high credit scores and large down payments or savings. Conditions in which a borrower has very high credit scores or large accumulated savings is referred to as compensating factors.
Two years of consistent, verifiable income can be difficult sometimes for those that are self employed, as many self-employed business owners take a great deal tax deductions each year and deduct as many expenses as they can from their gross business revenue, lowering their tax bill but also lowering their net income. This makes it hard for self-employed borrowers to show, on paper, that their business has a high earning potential or more importantly that the average of the business income actually qualifies for a mortgage loan based on the proposed mortgage payment and other debts of the borrower.
The problem with the self employed fundamentally rests the inability to produce filed tax returns that have sufficient monthly income to qualify for the home loan request.
Self-employed borrowers will generally have to provide a great deal of documentation to the potential mortgage lender to verify their income. This is because there is more room for self-employed individuals to embellish or exaggerate figures, so everything must be documented appropriately. A wage earner has less documentation to supply since the verification process is far easier as it generally involves the most recent w-2, current pay stubs and verification in writing or verbally of present employment. Clearly, that process would yield very little relevant information for the mortgage lender on a self employed borrower. In addition to standard loan paperwork, a self-employed borrower may also be required to provide the following:
Two years personal income tax returns
Two years of business income tax returns
A profit and loss statement
The following calculations are used by mortgage lenders to calculate the income of self-employed applicants – the applicant’s net income for the past two years based on the filed tax returns plus depreciation declared from the business. This gives a monthly average income that can be used to qualify for a home loan. Year to date income is measured but almost always ignored for qualification purposes as it can not be adequately verified. Expenses paid out of the business are not added back in to help increase the income, declared net income plus depreciation is the standard rule for calculating self employed borrower’s income.
If self-employed borrowers experience a great deal of difficulty when qualifying for a loan, they may consider alternative financing options other than a fully documented loan. One such option is stated income. These home loans have been sharply curtailed recently and are reserved for borrowers with excellent credit and substantial equity. Alternative documentation loans are suffering the same fate, however there are still programs available that allow alternatives such as the use of bank statements which add up the last 12 months of deposits to calculate an average monthly income.
Other options may include the compensating factors. A borrower who has limited income and therefore a high debt ratio may be able to qualify for a mortgage loan with a large down payment or large reserves after the down payment. In addition, have exceptional credit scores and limited debt outstanding will also help grease the wheels for a home loan approval.
The last resort may be seller financing. Sellers may require some credit checks, but may not require such extensive paperwork to verify income. The terms almost certainly will be less generous as well.
Though the paperwork for the self employed borrower may be more burdensome, if the income is consistent and the appropriate tax returns are used, there should be very little problems qualifying for all mortgage loan types. To check the possibility of qualifying for a home loan, a mortgage calculator can used to first calculate a two year average of monthly income and then the qualifying mortgage debt ratios. The mortgage calculator can be used to check debt ratios for a variety of home loans to see how well a borrower may meet the standard underwriting guidelines.
Home loans to purchase a property or for a mortgage refinance will have the same income qualification requirements for the self employed borrower. Good documentation is the key to a fast and painless home loan approval.
Getting a Mortgage for Home Improvements
If you are sitting in your home pondering a major expansion in the kitchen, finishing the basement, or completing key repairs of the home, a new mortgage is one potential source of funding for such a project. Of course, there are many sources of funding for these undertakings. Cash on hand, credit cards, or even personal loans can be used to help pay for work on your property.
The key advantage of mortgage funds is that the rate you pay on a mortgage is almost always the lowest rate for consumer borrowing. In addition, the interest paid on mortgage debt is generally tax deductible (seek the advice of your financial planner or tax advisor). Furthermore, if a borrower is to take a mortgage to extract equity or cash out of the property, one of the best uses for this cash is improvements that help increase or secure the value of that property.
The three main choices for getting cash out of your property for home improvements are: a cash out refinance, a second mortgage ( including a home equity loan and a home equity line of credit ) and specialty mortgages such as the FHA sponsored 203K loan and FNMA and FHLMC home loans that are periodically introduced to assist with home improvement financing. Since the 203K loans are a seldom used product and specialty loans come in and out of favor, these home loan types will not be covered.
Before discussing the various home loan options it is important how a mortgage lender determines the equity in your home. The equity in your home is the difference between the value or price of the house and the amount of mortgage loans you owe against it. A house that is valued at $200,000.00 with an existing first mortgage balance of $145,000.00 has $55,000.00 in available equity. Though this may seem like a fair amount of equity, a mortgage lender will provide a new home loan for only a percentage of the homes total value not all of the value. If a homeowner in this scenario were to obtain a cash out refinance for 85% loan to value, the amount of money obtained would be approximately $25,000.00. This is calculated by taking 85% of the home’s value or $170,000.00 and then subtracting the existing first mortgage balance to arrive at a lendable equity figure of $25,000.00.
Mortgage refinances are one of the most common methods for obtaining cash for home improvements. Refinance transactions are often 50% or more of all the loans originated across the nation every week with a great deal of variation depending on the level of mortgage rates. A measurable percentage of these refinance transactions are to extract cash from the property. This cash is used for an assortment of purposes; most mortgage lenders will tell you almost legal purpose is acceptable for a cash out refinance.
Fannie Mae and Freddie Mac do not establish rules on the home improvements a borrower may or may not finance with a new mortgage loan. Therefore an existing homeowner can obtain a cash out refinance to finish the basement, do repairs or add a new room to the structure. There are no limitations on the minimum amount or maximum amount of financing that needs to be spent on repairs. If a borrower obtains a cash out refinance to pay for home improvements the main consideration of the mortgage lender is the condition the property is in as well as what the funds will be used for.
Standard conventional home loans are made based on the existing condition of the property. This approach results in a standard new home loan qualifying based on the as is value of the property not the as-completed value. Deferred maintenance is the term mortgage lenders use to describe a property that is in disrepair. Minor deferred maintenance does not often raise any red flags. Significant deferred maintenance will usually have to be addressed by the appraiser when they inspect your property. The appraiser will generally attribute a dollar value to the amount of deferred maintenance.
If a property is presently in disrepair the mortgage lender will not a grant a conventional loan. If the property is going to have a significant structural change the mortgage lender may also be concerned about approving the home loan. Questions may arise as to who is performing the work as well as how and when it will be completed. Oddly, even though the mortgage lender based the decision on the home loan on the existing property condition and value if a new mortgage loan is going to impact the lenders collateral significantly, they will want to make sure precautions are taken such as a licensed contractor is performing the work. The improvements should be performed by contractors who are licensed, registered, or certified or have the highest level of certification required.
Other than the limitations on the loan to value for a cash out refinance the structural changes that may be performed, a mortgage refinance is straight forward and the guidelines are the same as they are for a purchase regarding credit, income and debt ratios.
Home equity loans and second mortgages are also an option and are considered interchangeable terms. These loans are mortgages you get after you already have a mortgage loan on your property. There two distinct different types of home equity loans or second mortgages, the home equity line of credit and the home equity loan.
The home equity loan is generally a fixed rate loan that taken out for a predetermined amount and is disbursed to you at one time. The home equity line of credit is also a predetermined sum of money but instead of getting the money all at once you are given a checkbook to access the available balance of the loan. Most all home equity lines of credit are based on a variable or adjustable rate.
These loans will have similar qualifying standards as first mortgages. The borrower’s income, debt ratios, credit and the amount of the loan relative to the property value or loan to value will be evaluated. When measuring the loan to value for a home equity loan the mortgage lender will add the first mortgage amount plus the propose second mortgage amount and divide that figure by the home’s value to come with a ratio called the CLTV or combined loan to value. If a homeowner has a home valued at $200,000.00 with a first mortgage of $125,000 and requests a home equity loan of $30,000.00 the original loan to value is 63% and the combined loan to value will add the home equity loan and would be 78%.
One of the main disadvantages of home equity loan is the mortgage rate on these home loan products is higher than the mortgage rates found on first mortgages. A second mortgage home loan is considered to be a more risky loan for a mortgage lender or bank. The mortgage lender charges a higher mortgage rate over a home loan that is in first position.
Aside from acquiring the loan you may need, make sure you pay attention to the increased expenses of home remodeling. Get at least three quotes and stay within a budget. Taking cash out of your property for home improvements is generally one of the best uses of the equity, often the cost of home improvements do increase the value of your home on a dollar for dollar basis.
There is an ample supply of mortgage lenders that will offer home improvement loans available. It is up to the homeowner to decide which one is the most suitable for their needs and budget. The first step should be to find out as much as possible about potential mortgage refinancing, home equity loans and the mortgage lenders. Utilize the mortgage calculators to help determine debt ratios, loan to values and monthly mortgage payments. Closely consider important factors such as mortgage rates, and closing costs. Shop and compare home loans carefully before making a long term commitment.
Q. What happens when you change the mortgage loan amount after the loan application is with the mortgage lender?
A. Generally this is not a big problem when the loan amount is altered by small amounts, but it will depend on a number of variables of which one may be significant. Mortgage loans are almost entirely approved or denied based on automated underwriting systems or programs or AUS. The two biggest are FNMA’s Desk Top Underwriter and FHLMC’s Loan Prospector program.
Once a home loan application is preliminarily approved that is an indication it has been submitted through one of these programs. The loan approval takes only minutes but the data entry and processing leading up to the approval may take an hour or more. Once the home loan is submitted the automated system will generate an approval with conditions or findings that need to be satisfied for final loan approval. The conditions usually involve items and procedures such as employment and income verification and supporting documents such as current paystubs or asset documentation. The key is that the mortgage loan request is approved based on several numerical factors such as the applicants credit score, debt ratios, income and assets not subjective judgments performed by an individual.
Altering the loan amount after the initial input in these automated underwriting systems is relatively easy. Once a mortgage loan request is entered into one of the automated underwriting programs the loan request can be altered multiple times without recourse. Each alteration does not change the credit profile or cause another inquiry into the applicant’s credit report. The credit score doesn’t change due to a higher loan amount nor does the applicants job or income. If an increased loan amount is not accepted it does not invalidate the prior approval amount and conditions.
Raising the home loan amount is most often a minor change that impacts the debt ratio slightly as well as the LTV or loan to value. It would also be easy to see that a loan increase of $3,000.00 on a $200,000.00 loan request is not going to raise the mortgage payment very much and therefore will have very little impact on the debt ratios. This can be verified by running your own mortgage payment calculations on a mortgage calculator. Therefore, unless the debt ratios are very tight the most significant factor in determining the outcome of increasing the loan amount is the loan to value.
This leads to the conclusion that for home loans that are already approved, raising the loan amount slightly should be relatively easy. It requires some simple data entry changes into the original approval request with the automated underwriting system and viola, a new loan approval.
However, if the loan request is for a home purchase, the loan amount change may very well be changing the down payment and the loan to value significantly. A home loan for 180,000.00 on a $200,000.00 purchase that changes to a $182,500.00 loan amount involves a fairly measurable change to the LTV. The original home loan request calls for a down payment of $20,000.00 or 10% of the purchase price which is equivalent to a 90% loan to value home loan. By raising the loan amount by only $2,500.00 the loan to value is now over 90% (91% or $182,500.00 / $200,000.00). Home loan requests that may alter the LTV above the minimum accepted level are likely not to be approved.
The first step to solving the question of whether your mortgage loan request can be increased is to run the loan figures on a mortgage calculator so you know how the loan amount changes are impacting the mortgage payment and debt ratio. Next, speak to the loan officer or mortgage lender and ask for their input. For a refinance it is fairly common for the loan amount to be changed. Underwriting considerations may prevent the mortgage lender from raising the loan amount but there is no downside to asking. If the credit, income and collateral allow room to change the mortgage loan amount, it should a fairly simple process.