While FHA mortgage applications are generally submitted through automated underwriting systems (AUS), the ultimate decision rests with human underwriters. That’s a good thing, because while some mortgage applicants would easily qualify for a loan anywhere, and others are unqualified, the majority fall in between those extremes.
FHA guidelines frequently use the words “reasonable” and “sensible” and allow underwriters some discretion as long as they can justify their decisions. The purpose of underwriting is to determine a borrower’s ability to repay a mortgage and limit the likelihood of defaulting. In addition, underwriters determine if the subject property is appropriately valued.
Typically, underwriters review:
- Willingness to pay (credit history)
- Ability to repay (debt-to-income ratio)
- Assets (cash available to close and reserves)
- Collateral (the home’s condition and value)
Here is a rundown of borrower characteristics that can get applicants a bit more leeway, and those that cause underwriters to be a bit more conservative in their recommendations.
FHA says that your credit history, not your score, is a reliable indicator of your risk.
Past credit performance serves as the most useful guide in determining a borrower’s attitude toward credit obligations and predicting a borrower’s future actions. A borrower who has made payments on previous and current obligations in a timely manner represents reduced risk. Conversely, if the credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments, and delinquent accounts, strong compensating factors will be necessary to approve the loan.
While conventional underwriting guidelines may say that your debt-to-income ratios shouldn’t exceed 41 percent (your housing payment plus payments on other credit shouldn’t exceed 41 percent of your gross income), FHA goes further. If you have a high debt-to-income ratio because of maxed out credit cards and a boat, you get a lot less leeway than if it is because you have a low-paying job.
“Payment shock” describes the relationship between your current housing expense and what it would be if your mortgage application was approved. For example, if you currently pay $450 a month in rent, but apply for a mortgage with a $2,000 a month payment (including taxes and property insurance), underwriters are very concerned about where that extra money will come from. Payment shock is calculated by dividing the new payment by the old payment, and in this case, $2000/$450 is 444%!
Payment shock becomes a concern when it exceeds 150%. By itself, payment shock won’t get your mortgage declined, but it does count against you. For example, if the source of your down payment is a gift (because you have no savings), and your new payment will be twice your current rent expense, an underwriter may be reluctant to approve your loan. If you were unable to save any money while renting, how will you find the money to pay twice as much for housing if your loan is approved?
On the other hand, “reverse payment shock,” when your new mortgage payment will be lower than your current housing expense, is considered a compensating factor that may allow you to borrow more than you would otherwise, especially if you have shown the ability to pay housing expenses greater than or equal to the proposed monthly expense for the past one to two years.
Saving regularly, even if it’s just $10 a week, could get underwriters to overlook the fact that your credit report doesn’t have much information (this is called a “thin file”). Regular deposits to a savings account can even be used to beef up your credit, because regular payments to yourself are considered similar to regular payments to a creditor.
Savings also contributes to another compensating factor called “reserves.” “Reserves” is the term for savings that could be used to pay your mortgage if your income dropped. For example, if your total mortgage payment is $2,000 per month, and you have $3,000 in savings, you have 1.5 months of reserves. Two or more months of reserves (after closing on your loan) are considered a compensating factor, and of course, more is always better.
Equity or Down Payment
One of the best ways of reducing any doubts underwriters have about you is to make a larger down payment than necessary. The more home equity you have, the less risky your mortgage is. So, while your minimum down payment is 3.5 percent, putting five, ten or even more may get your application approved even if your credit is a bit stinky.
Underwriters are tasked with considering not just how adequate your income is at the time of your mortgage application, but how stable it is and what’s likely to happen in your future. If your resume is littered with six-month stints in low-level positions in different industries, lenders are understandably concerned. On the other hand, if you have steadily moved on to greater responsibility and increased income, that says something else. And if you just graduated from medical school and obtained a lucrative position with a prestigious hospital, the fact that it’s your first medical job will probably be overlooked.
Other Income Sources
What if you have a second job? Or you moved to take a new position, and your spouse hasn’t found a new job yet but fully expects to soon? This income can’t be counted in your ratios until it’s well-established, but it may be considered as a compensating factor.
Taking a homebuyer education class may get you extra consideration, especially if you’re a first-time buyer. It shows underwriters that you’re serious and committed to home ownership, and that you may be better equipped to meet its challenges than your application package indicates.
One negative that may get you into hot water is an account statement showing a slew of bounced checks, or an account verification form from your bank that reveals a pattern of non-sufficient funds (NSF) transactions. It makes you appear irresponsible with money.