Question: We want to apply for a mortgage but are worried we don’t have enough income. A loan officer told us we might have extra borrowing power as a result of “compensating factors.” This gives us hope, but what is a compensating factor?
Answer: The mortgage industry is moving as quickly as it can toward automation. In an ideal world, home buyers and refinancers will type in their names and a few other pieces of information and the computer will instantly determine their ability to get a mortgage.
This sounds great in theory, but in practice we all tend to be a little different and one result is that the lending system has a few fudge factors built-in. The good news is that such flexibility tends to benefit you.
For example, loan programs often have a strict debt–to–income ratio (DTI), say not more than 43 percent.
In other words, up to 43 percent of your gross monthly income can be used for housing expenses such as the mortgage, property insurance, property taxes and recurring debts which might include auto loans, minimum credit card payments or student loans.
If the DTI ratio can somehow be higher, a home buyer might obtain a larger loan or more readily qualify. This is where compensating factors become important.
A compensating factor is really just an adjustment that lenders can make. However, they can’t just fudge the numbers. They have to operate within the requirements of the loan for which you are applying, and they also must meet their own standards.
What are examples of compensating factors? The answer varies according to the loan program and the lender. However, a good basic list looks like this:
When homes have better energy efficiency it means that homeowners have lower monthly costs for utilities. If a home meets certain energy efficiency standards the lender is often able to increase the DTI ratio.
Lenders really dislike the idea of risk. The less risk represented by a given loan, the happier the lender.
If a lender sees that you have good savings habits and as a result have bulked up your cash reserves, they may be able to adjust your DTI higher.
As an example, if you have reserves equal to three monthly mortgage payments or six monthly mortgage payments in addition to all the projected costs to acquire the property, the lender is likely to be ecstatic.
By traditional standards, it may not seem like a big deal to have a few months of savings socked away. However, millions of Americans simply don’t save. The evidence? A study by the Consumer Financial Protection Bureau (CFPB) estimated that the typical payday loan amounted to less than $400.
If you have been renting for some time at a given monthly rate — and your new mortgage payment will be similar, perhaps less than your current rental cost, or even a touch higher — lenders will be happy to consider that fact when reviewing your application.
In a sense, they know from your rental history you will be able to handle the new monthly payment, and that reduces lender anxieties.
Minimum discretionary debt
It’s okay to have a mortgage application which shows debt. After all, an applicant with both savings and no debt is fairly rare. What lenders would like to see for those who do have debt is that it meets certain standards.
With FHA financing, little or no discretionary debt can be a compensating factor according to HUD:
- When the Borrower’s housing payment is the only open account with an outstanding balance that is not paid off monthly.
- If the credit report shows established credit lines in the Borrower’s name open for at least six months.
- The Borrower can document that these accounts have been paid off in full monthly for at least the past six months. One reason to keep checks and bank statements is to document payments.
Not all income earned by applicants can count toward their qualifying income. For example, a bonus here and there or some extra overtime are unlikely to help your qualifying income level.
However, if additional income can be documented for at least a year, the lender may be able to use such income is a qualifying factor.
The VA loan program qualifies borrowers in part by looking at what is called “residual” income. Since VA financing has very few foreclosures, the residual income standard can be seen as a strong measure of financial stability.
The idea of residual income is to see how much cash a borrower has at the end of the month given income, family size, and location. The more cash the better. Lenders can sometimes use the same system to create a compensating factor for non-VA loans.
The bottom line
When speaking to lenders, ask if you qualify for a little assistance through the use of compensating factors. You may not need them to qualify, but if you do they can mean the difference between getting the loan you want versus a mortgage which is too small or maybe even an application which is declined.