When aiming to qualify for a mortgage, lenders consider various factors such as your credit score, debt levels, income stability, and savings. If any of these aspects is not in balance, it may require attention before approval.
However, life can bring unexpected challenges. Perhaps you accumulated debt during college, but you’re actively addressing it and have savings. Or maybe your credit history has a few blemishes, yet you maintain a solid income and steady job. In such cases, you might still meet the requirements for a Federal Housing Administration (FHA) loan. These qualifying aspects are known as FHA compensating factors, and we will delve deeper into them.
Understanding Compensating Factors: When and Why They Are Essential
A compensating factor is like a bonus point that shines favorably on you in the eyes of an underwriter – the person deciding if you’re eligible for a mortgage. These factors help balance out any shortcomings in other areas.
For instance, a borrower with a low credit score, modest income, or high debt-to-income ratio (DTI) might offset these with strong compensating factors elsewhere in their application.
Understanding FHA Guideline Basics
To ensure ongoing speed and performance improvements, it’s crucial for runners to include strength training in their workout routines. When considering FHA loans, certain guidelines need to be followed. Typically, a minimum credit score of 500 is required, along with a 10% down payment or equity for approval with such a low score. Lenders often have their own specific criteria. Most lenders stipulate a 3.5% down payment and a FICO® Score of 580.
In many instances, loans may undergo an automated approval process. If the system deems you an acceptable risk for the FHA based on the information provided, your application can proceed. Should your application be declined by the system, there’s still the possibility of a manual underwriting process by a lender. The FHA imposes strict limits on the percentage of your gross monthly income that can be allocated to your mortgage payment and overall debt-to-income (DTI) ratio. For instance, with a credit score of 580 or higher, manual underwriting may require your mortgage payment not to exceed 31% of your income and an overall DTI of no more than 43%.
In cases where certain compensating factors are present, the housing expense ratio for a manually underwritten loan can be increased to 40%, and the overall DTI can go up to 50%. This allows qualification with slightly higher monthly payment obligations, highlighting the importance of compensating factors.
It’s important to acknowledge that each lender establishes its own policies based on FHA guidelines and their risk tolerance. Additionally, the mortgage payment must not surpass 31% of your gross monthly income, and the overall DTI cannot exceed 43%.
Factors Considered by Lenders for FHA Loans: Understanding the Compensating Elements
A lender evaluating an FHA loan weighs various compensating factors. Let’s delve into them shortly.
Savings (Cash Reserves)
To secure a mortgage, lenders typically require proof of having enough savings to cover several months’ worth of mortgage payments. This safety net, known as cash reserves, ensures that you can manage your mortgage in case of income loss.
According to FHA guidelines, having three months’ worth of mortgage payments saved can be a compensating factor when purchasing up to two units. For three or four units, six months’ worth of payments is necessary.
Cash reserves play a significant role in why mortgage lenders assess your assets. They seek assurance that you have accessible savings. Per FHA rules, assets can include anything not allocated for closing costs, except for gifts, borrowed funds, or cash from the mortgage closing.
Low Debt Ratios
Your debt-to-income ratio plays a crucial role in determining your affordability, alongside factors like down payment and interest rate. To calculate it, total up your installment and revolving debts, then divide by your gross monthly income. Convert the result into a percentage by shifting the decimal two places.
A lower DTI is favorable, offering leeway for a larger house payment. Maintaining a DTI below 36% signals financial prudence. Notably, FHA recognizes having no discretionary debt as a compensating factor. This means your sole remaining unpaid balance each month should be your mortgage payment.
Steady Income Source
Having a stable job ensures a steady income stream, which in turn boosts your ability to meet mortgage payments. This financial stability works in your favor as a compensating factor.
Residual income refers to the pretax income remaining after settling personal debts and expenses. A surplus of funds at month-end is favorable, indicating your capability to navigate income reductions effectively.
Understanding Variable Income
When seeking a mortgage, lenders focus primarily on your consistent income, such as salary or hourly earnings, as it is expected to be ongoing. However, other income sources should not be disregarded.
If you have received substantial income from any of the following categories in the past, it may enhance your eligibility for qualification:
- Overtime
- Bonuses
- Part-time work
- Seasonal income
- Commissions
Down Payment
While the FHA doesn’t expressly mention a larger down payment as a compensating factor, it does reduce risk for lenders. A substantial down payment lowers your monthly payment compared to those with smaller down payments. Moreover, a sizable upfront investment makes you less prone to default. The commitment you’ve made upfront motivates you to stay current on payments to safeguard your initial investment.
Credit History
A higher credit score may not be explicitly cited as a compensating factor, but it can lead to a higher DTI ratio acceptance by lenders and the FHA, especially when approved through their automated underwriting system. Your credit score, alongside your down payment, significantly impacts your interest rate.
Generally, the higher your score, the more favorable the rate. This is because a strong credit history indicates to the lender that you’re likely to meet your mortgage payments consistently. Beyond the score, lenders also assess your credit report for signs of financial responsibility, such as a lack of late payments or collections.
Key Takeaway
If you’re teetering on the edge of FHA loan qualification, certain compensating factors can tip the scales in your favor. These factors can be especially beneficial if you’re contending with a lower credit score or slightly higher debt.
Having gained some insights, delve deeper into government loans. If you feel prepared to secure mortgage financing, take the next step by applying online or reaching out to us at 719.445.2959.
Reed Letson
Reed offers two decades of expertise as a mortgage broker, focusing on veterans and first-time home buyers. With a strong grasp of real estate and mortgage markets, he empowers clients with practical insights. Reed's passion is guiding clients to build wealth through real estate investments and financing solutions.