Mortgage lender overlays are additional requirements on top of the published requirement by a loan program. The government-backed programs, FHA, VA, and USDA are often the most common programs that have lender overlays. However, it’s not unheard of for lenders to make the conventional loan guidelines a little stricter too.
So what lender overlays are the most common?
Low Credit Scores Make for Risky Loans
Many of the government-backed programs have low credit score requirements, with the FHA being the lowest. They allow credit scores as low as 580 and still allow borrowers to put just 3.5% down on the home. They also allow credit scores as low as 500 with at least a 10% down payment. You’ll be hard pressed to find a lender willing to offer a loan with either of those credit scores.
Lenders often increase the credit score requirement in order to reduce the risk of default. Even though the FHA, or the other government entities, guarantees their loan, it doesn’t mean a lender wants the default in the first place. It’s more common to find lenders that require a 620 or 640 credit score on FHA loans.
The same goes for the other government-backed loans. The VA doesn’t have a minimum credit score requirement, but most lenders enforce a minimum 620 credit score. The USDA is the only government entity with a slightly higher credit score requirement of 640. Since they provide 100% financing, though, some lenders require a higher credit score.
Low Down Payments Can be a High Default Risk
Conventional, FHA, VA, and USDA loans all have low down payment requirements. You can get a conventional loan with just 5% down if you have a credit score of at least 680. It’s common for lenders to require a higher credit score in order to put that small amount down on the home, though. Many lenders require at least a 700 credit score before they allow just 5% down. If they do allow the lower credit score, they often increase your interest rate to make up for the risk of default.
The FHA program requires 3.5% down with a score of 580, but as we discussed above, most lenders require a higher credit score for that down payment. If they do accept a low credit score, they will typically bump up the down payment requirement. The more ‘skin in the game’ a borrower has, the less likely he is to default on the loan.
Some Property Types are Riskier Than Others
Some lenders are picky about the type of property you buy too. Even though the FHA, VA, and USDA have specific guidelines that a development must meet in order to get financing on it, lenders are still choosy. Condominium and townhome developments usually pose the largest issue.
Even if the development has HUD approval, many lenders will not provide funding on these types of properties. They are a higher risk of default just because of the number of factors involved in the property’s value. Condos and townhomes rely on the responsibility of everyone in the development, not just the homeowner of the unit the bank financed. Because of this large risk, lenders often add their own rules onto what the loan program requires to minimize their risk.
High Debt Ratios are High Risk
Debt ratios are another area where many loan programs seem to be rather forgiving. Lenders are not on board with the allowance of high debt ratios though. They would rather you had a lower debt ratio or compensating factors to make up for that high debt ratio.
Each lender can set their own requirements for the debt ratio. Some want them as low as conventional guidelines, which is a 28% housing ratio and 36% total debt ratio. Others will have slightly more forgiving ratios, but tighter restrictions than the particular loan program allows.
Reserves Play a Large Role in a Borrower’s Approval
Most loan programs don’t have reserve requirements, but lenders often require them. If you apply for a loan with a low credit score and high debt ratio, you can bet that a lender is going to require you to have reserves available.
Reserves are money you have in a liquid account, such as checking, savings, stocks, bonds, or mutual funds. You can turn these funds into cash and pay your mortgage if something happened to your income. Lenders count reserves based on the number of months of mortgage payments they can cover. Some lenders have a specific number of months you must have in reserves before they will approve you for a loan.
Each lender will have their own rules. It pays to shop around and see what each lender requires before you settle on a loan program. This will allow you to see what other lenders have to offer not just in requirements, but in interest rates and fees too.