Compensating Factors: Building a Case for Your Mortgage Approval

September 20, 2016

Would-be homeowners sometimes avoid moving forward because there is something in their financial profile that they feel will prevent them from obtaining a mortgage. You could be weak in credit or have not quite enough income to qualify to purchase the house that you want. But the mortgage industry makes widespread use of what are known as compensating factors. If you have a couple of these, they may be able to overcome weaknesses elsewhere in your profile.

What Are Compensating Factors?

Compensating factors are strengths in your financial profile that can be used to offset weaknesses. The chief mortgage underwriter in the first mortgage company I worked for used to say “give me something to hang my hat on” anytime a loan came in that had one or more significant weaknesses. Put another way, what he was saying was “give me tangible reasons to approve this loan.”

That’s basically what compensating factors do. Let’s say that you have credit that would best be described as fair. A mortgage lender may be reluctant to approve your application under the terms that you request. But if the application contains several compensating factors, the approval may be granted.

Skilled mortgage personnel will know how to develop compensating factors that will offset negatives in your profile. But you should still know what they are so that you can help your own cause.

Weaknesses that Compensating Factors Can Overcome

The two most common weaknesses center around credit and income. Now let’s be certain from the start that if you have problems concerning both at the same time, it will be difficult to get your loan approved even with strong compensating factors. So what we’re talking about is either credit or income as a problem. That’s where compensating factors can help.

For example, let’s say that your income isn’t sufficient for the loan you are requesting. If you can show compensating factors, such as making a large down payment, or having significant cash reserves after closing (we’ll discuss both in the next section), a lender may be enticed to approve your loan anyway.

Credit issues are more difficult, and usually require several compensating factors to offset. It may even require that you add a cosigner to the loan to get approval. However, if you have compelling compensating factors, that may not be necessary.

Typical Compensating Factors

Here are common compensating factors that can be used to overcome weak credit, insufficient income, and sometimes both. That isn’t to say that compensating factors will overcome a significant lack of income or a poor credit history. But if your situation is even close in either category, strong compensating factors can put you over the top.

Large down payment. Most borrowers are in a minimum equity position, particularly when it comes to purchasing a new home. If you make a down payment equal to at least 20% of the purchase price, this is a compensating factor that will it make easier to approve your loan. Please be aware however that down payment cannot be comprised primarily of a second mortgage or a home equity line, but must be actual money invested in the transaction.

Low non-housing debt. Mortgage lenders usually look for the new monthly housing payment to not exceed 28% of your stable monthly income. If it does, but you have little in the way of non-housing debt, this can be a compensating factor.

Small increase (or decline) in a house payment. If you’ve been successfully managing your current house payments, whether they are for rent or a mortgage, a strong compensating factor is when the new house payment will be no more than 10% higher than the current one. The lender can reason that if you’ve successfully managed a comparable house payment in the past, that you will have little trouble in the future.

Large cash reserves after closing. Cash reserves are liquid savings that you have available after the closing. Lenders generally require that you have an amount sufficient to cover at least two months of the new housing payment. If you have significantly more, say at least six months worth, this can be a compensating factor.

Large asset base. Some people with relatively modest incomes are skilled at acquiring a large amount of savings. This can be in the form of liquid savings, like bank accounts, or investments and retirement savings. A large asset base is a strong compensating factor, even if you don’t use it to increase the down payment. It is an indication of overall financial strength that makes it less likely that you will default on the mortgage.

Additional income not used to qualify. Sometimes the reason for insufficient income is income that is not recognized by the mortgage lender. For example, if you receive bonuses or overtime, the lender will not use it to qualify unless it has been happening for at least two years. But if you have been receiving it for over one year, that represents a compensating factor, even though it is not used to qualify you for the loan.

Strong career growth potential. This is a factor that primarily benefits younger borrowers. Let’s say that you are recently out of school, and not making a lot of money. The lender may be willing to stretch the income guidelines if you’re working in a career that has strong upside potential. For example, this can include being a doctor right out of medical school, or an engineer or IT professional right out of college. Though your income may be low now, it’s easy enough to project that it will rise rapidly soon.

Exceptional credit history. This can be a compensating factor if income is a problem. The fact that you have managed your credit well in the past, evidenced by a credit score of something like 800+, can be a compensating factor.

There are other compensating factors, but these are some of the more common ones. If you are weak in any areas of your loan application, you should determine how many of these might apply to your situation.

How to Develop Your Own Compensating Factors

If you are applying for a mortgage and concerned that there may be issues regarding either your income or your credit history, you should make an effort to identify any compensating factors that may exist in your profile.

The reason that this is a necessary step is that a compensating factor only matters if it can be documented. For example, if you have a lot of financial assets, you should be prepared to document these with statements proving their existence. You should be prepared to do this even if those assets will not be required for the down payment and closing costs.

Another would be documenting additional income not used to qualify. For example, if you regularly work overtime, but haven’t done so for at least two years, you should still document the additional income with paystubs and W2s. If you have a profitable side business, you should be prepared to provide a tax return showing the income. The lender can’t use it to qualify you for the loan, but they can use it to justify higher debt ratios.

And if you’re in a position to do so, one of the strongest and easiest compensating factors is to increase the size of your down payment. It always increases the chance that your loan will be approved. For example, if you are prepared to make a 20% down payment, consider making a 30% down payment.

Your mortgage lender will work with you to develop compensating factors. But you can help your case by knowing what they are, and being prepared to document them in advance.

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