When applying for a mortgage lenders look at all aspects of your loan application to determine the amount of risk a borrower represents.
If you have a low credit score then lenders will want to see things like a large down payment or a low debt-to-income ratio to help offset the risk, these are called compensating factors.
In this article, we’re going to look at situations in which you will need compensating factors and what those factors are.
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What are Compensating Factors?
Compensating factors are positive aspects of a borrower’s loan application that help offset the negative such as bad credit or low income.
If a borrower barely meets the minimum credit requirement for a mortgage the likelihood of them getting approved is low unless they have compensating factors that make their loan application more attractive to lenders.
These compensating factors can be anything that improves your ability to make the monthly mortgage payments.
* Limited payment shock
* 5+ years with the same employer or in the same industry
* High income
* Large amount in savings
* Good credit
* 20% down payment
* Low debt-to-income ratio below 36%
* Residual Income
* Limited debt (credit cards, auto loan, etc.)
When You will Need Compensating Factors
Usually, compensating factors are needed when a borrower is on the lower end of mortgage lenders’ credit requirements, or on the higher end of the debt-to-income ratio guidelines. But if your income is low, you have a lot of debt, or you don’t have reserves in savings after coming up with your down payment.
- Low credit score
- Low income
- High debt-to-income ratio
- Limited savings
- High payment shock
FHA Compensating Factors for Low Credit, DTI Ratio up to 50%
FHA mortgage loans have some of the most lenient borrower requirements of any type of home loan. Borrowers with credit scores as low as 500, or with a DTI ratio of 50% may be eligible if they have compensating factors.
Debt-to-Income Ratio – The maximum DTI ratio allowed by most lenders is 43% and up to 50% in some cases. Having a DTI ratio of 36% or less is considered a huge positive.
Good Credit – Having good credit (700+ credit score) can compensate for a lot of negatives. If you have a high DTI ratio, lenders will still work with you if you have sufficient credit.
Cash Reserves – Lenders want to see you will have case reserves in savings after closing in case any emergencies arise. Having at least three months of mortgage payments in savings is a compensating factor.
Minimal Payment Shock – Payment shock is the difference between what a borrower is currently paying in housing costs compared to what their mortgage payment will be. If a borrower has been paying $1,500 a month for rent then there’s a good chance they can afford a $1,500 mortgage payment.
Steady Employment – Mortgage underwriters like to see job stability in applicants especially if they have credit issues or a high DTI ratio. Being with the same employer for 3+ years is likely to help strengthen your loan application.