Here’s the scenario: You’re getting closer to the home of your dreams in Dallas, TX. Your research shows you’ll qualify for the mortgage you want, based on minimum eligibility guidelines. Everything seems very black-and-white — until your lender says you don’t actually qualify, or there are additional requirements to meet before you receive that coveted stamp of approval on your loan application.
Record scratch! What’s the discrepancy? If Federal Housing Administration (FHA) loans allow a credit score of 580, why would a lender require 640?
While there are clear mortgage guidelines set forth by government agencies, lenders are allowed to tack on additional requirements, called lender or mortgage overlays. These provide another level of protection between lenders and the borrowers they believe are more likely to default.
“Everything boils down to risk,” says Mike Shaw, a mortgage broker with Shaw Financial in Littleton, CO. “Fannie Mae, Freddie Mac, VA, and FHA have set their minimum risk level, but lenders are always able to increase that. Lenders build overlays so they can manage their risk and feel like they can offer a good product with better rates.”
If you’re searching for a mortgage, there are a few important things to know about lender overlays and how they might help or hinder you in landing the best rates and terms on your mortgage.
1. There are common factors that spark mortgage overlays
While a lender overlay could come into play simply because the property you’re buying is deemed “riskier” — as is the case with condos and homes in declining areas — there are a few common financial areas where lenders might establish stricter requirements.
- You have a moderate credit score. Your score might be above average, but anything below 740 poses some risk to lenders. This could mean your score isn’t high enough to qualify with that lender and that product, or you will be required to make up for it in other areas.
- Your debt-to-income (DTI) ratio is high. Lenders use your debt-to-income ratio — your monthly debt obligations divided by your monthly gross income — to determine whether you’re financially able to take on the mortgage you’re after. Some lenders will turn down borrowers with a high DTI, even if it fits within minimum mortgage requirements.
- Your job history is short or unstable. A longer job history indicates financial stability, and some lenders think that requires more than six months. This could mean a costlier loan or more scrutiny placed on other areas of your application.
- You have a short credit history. If you aren’t a seasoned credit holder, it’s more difficult to determine a track record for how you handle credit. Some lenders want to see more than one or two lines of credit that are only a few years old.
2. Loan type can make you more susceptible to lender overlays
Since FHA loans have notoriously low requirements, they tend to be the top contender for additional mortgage overlays, Shaw says. FHA guidelines state, for example, that borrowers can qualify with a credit score of 580 or above and a minimum down payment of 3.5%. With a down payment of at least 10%, credit score requirements dip below 580. However, many lenders have scrapped this credit score guideline, opting for a minimum of 620 or more, regardless of the down payment size. This doesn’t mean you can’t find a lender that sticks to the FHA minimum guidelines, but the pool of lenders will be smaller — and the trade-off could be in the rate you receive.
3. There are ways you can get around mortgage overlays
If you’ve already checked off the boxes of an attractive borrower — healthy credit score, low debt-to-income ratio, substantial job history, high down payment — avoiding lender overlays probably isn’t necessary. In fact, if you can be approved despite lender overlays, you might even take advantage of lower rates and more favorable loan terms. However, if you’re on the cusp of receiving loan approval but overlays are keeping you stuck, there are options.
Shop around. Mortgage overlays vary and some lenders don’t have any overlays. Being turned down for a mortgage from one lender doesn’t mean it’s the end of the road; it could just mean you should look elsewhere.
Work to improve your financial situation. Tackle things like paying off debt to lower your debt-to-income ratio and improve your credit score. This can make you look like a much better loan candidate and potentially land you better loan terms.
Bring more cash to the table. A larger down payment and higher cash reserves can make up for things like a low credit score. Lenders want to see a financial commitment, and this can help substantially.
