Lender's Mortgage Overlays in a Nutshell
A famous line from the old movie “The Wizard of Oz” involves the character Oz shouting out “pay no attention to the man behind the curtain!” The little guy behind the curtain was trying to protect his image as a strong, powerful leader. From this movie scene spawned the expression “let’s pull back the curtains”, meaning, “let’s see what type of work REALLY goes on when people are not paying attention.” Today we are giving you a chance to peek behind the curtain of the mortgage world and get an idea of what happens at individual banks and mortgage companies in the form of mortgage overlays.
Mortgage Overlays in a Nutshell
Technically speaking, a mortgage overlay are specific rules a lender follows ABOVE the published guidelines for lending money in the form of a mortgage. Each lender will usually have their own internal mortgage overlays that are applied to mortgage loans along with the rules set forth by Fannie Mae, Freddie Mac, FHA, VA and USDA.
The mortgage overlays are determined by the lender’s ability to handle risk as well as the current economic conditions. This means that the overlays can get stricter in tough economic times and become more lenient in prosperous times.
All Checking Accounts Are Not Created Equal
To explain mortgage overlays, consider this example. A small, local credit union may offer checking accounts to all their members. The credit union states that the following rules and conditions apply to their checking accounts:
- Member must pay $10 yearly for a debit card
- Checking account does not pay any interest
- Only 10 written checks per month are allowed. More than 10 will incur a fee
Compare that checking account to a checking account offered by a large, national bank on the other side of town. Their account allows the following:
- Free debit cards
- unlimited checks per month
- account pays 2% interest on balances averaging at least $500 for the month
Both institutions offer a checking account. Both institutions give their customers access to their money. But you can see that one is clearly more advantageous.
The same can be said for lender overlays. One lender may approve an FHA loan for a customer with a credit score of 610 while the competing lender across town requires at least a 650 credit score for the same FHA loan. It is up to the discretion of the lender.
Specific Overlay Examples
Here are some specific examples of different mortgage overlays in relation to the published mortgage guidelines.
- Debt to Income ratio – The guidelines offered by FHA state that the maximum debt to income ratio is 56.9% so long as the customer has a minimum credit rank of 620. However, specific lenders will not approve a loan if the debt to income ratio is over 43%
- Minimum credit scores – FHA states that a credit score of at least 580 is all that is needed for loan approval. But, the majority of lenders require a score of 620 to 640 in order to be considered for any type of home loan.
- Down Payment requirements – Fannie Mae and Freddie Mac have clear rules that allow borrowers to buy a home with only a 5% to 10% down payment using a conventional mortgage. However, if a person’s credit score is below 700 or if their debt to income ratio is on the high end, there may be an issue. The lender may increase the interest rate on the mortgage by 0.125% up to 0.50%. Or, they may require a bigger down payment.
- Bankruptcy requirements – After a person is discharged from bankruptcy they may apply for a mortgage loan. However, most lenders ask customers to wait at least one year and as much as two years once the discharge is complete. Lenders will go so far as to require specific waiting periods for different types of loans.
- Property types – The VA mortgage is available to veterans for almost any kind of property. But, certain lenders may not offer a VA mortgage for a condo or a manufactured home.
- Credit History – Having a diverse range of credit lines is often a good way to boost your credit score and prepare for a home loan. Lender overlays may require a certain number of credit accounts along with a minimum number of years of payment history in order to qualify for a loan.
- Minimum Reserves – In the mortgage world reserves are used to describe cash assets owned by the borrower. Typical examples include checking accounts, saving accounts, money market accounts, certificate of deposits, stock and bond investments and retirement accounts. The mortgage guidelines may not require a specific amount of reserves or only enough reserves to cover 2 or 3 mortgage payments. On the contrary, a lender may have a set rule that all conventional loan approvals require the borrower to have 6 months of reserves.
These are just a few examples. Basically, each lender decides what parameters it considers too risky and which criteria it is willing to accept. While it is possible, it is not likely that a single lender would have all of the overlays listed above.
In most cases, lenders may approve borrowers with a caveat; they will need to pay more fees at closing or they will need to agree to a higher mortgage rate. The higher fee is usually calculated as a percentage of the overall mortgage loan.
How Mortgages Work
In order to understand why lenders add these additional rules to mortgage loans it is necessary to have a basic idea of how mortgages work on the big scale.
Lenders, such as local banks, credit unions and mortgage brokers, take in applications from consumers for mortgage loans. The applications are compared to various loans offered by FHA, VA, USDA, Fannie Mae and Freddie Mac. Once the lender determines the best loan for the consumer the loan is processed, approved and finalized.
The lender will then sell the mortgage to a bigger lender. The bigger lender will take a group of similar loans, such as several Fannie Mae loans, and sell them as investments. This is why you may get a loan with City Bank but then 3 months later receive a letter that states “please make all future payments to American Mortgage Investment Inc.”
When a large lender buys up loans from smaller lenders, the smaller lender frees up their money in order to make more loans.
Lenders know that if they have a loan that has met all the guidelines for an FHA mortgage, for example, and met the additional overly requirements, then that loan should be easy to sell to another, larger lender.
So Why Do Lenders Use Overlays?
Now that we have established the foundation of how mortgages work and how lenders use overlays, we can get to the main question; why do lenders even have mortgage overlays? The answer can be summed up in one important word: RISK.
Lenders are trying to reduce their level of risk by doing everything within their power to ensure that the loan will be paid back.
In a perfect world, everyone that signs up for a mortgage would make their payments on time and own the home free and clear at the end of their payments. However, nothing is perfect. People get sick, lose their jobs, go through a divorce and a whole host of other problems that cause financial stress. This results in people either making late payments on their home loan or tossing up their hands in defeat. When people stop paying their mortgage it is called a default and the foreclosure process begins.
If one lender has several loans that are paid slowly, or goes in to default, they may lose their ability to sell future mortgages to particular lenders. In a worst case scenario, the lender is forced to buy back a mortgage that they previously sold.
Mortgage lenders are in the business of making home loans in order to turn a profit, not buy back mortgages that were previously sold to a large investment firm. Therefore, based on their own track record or based on knowledge gained directly from large investment firms, mortgage lenders will put lender overlays in place to steer away particular types of home applicants. Their hope is that the right mortgage overlays will greatly reduce their overall risk and allow them to enjoy a profitable venture with mortgage loans.
How to Get a Loan and Avoid Problems with Mortgage Overlays
With all of this information about risk and additional fees for various situations, you may be wondering how to get a mortgage and avoid these issues. The answer is simple, but not always easy. In order to qualify for a mortgage at the best rate possible, get your entire financial plan in top shape. This means paying your accounts on time, keeping your job for at least 2 years, have a range of credit accounts and keep your overall debt low. If you can accomplish these 4 things, and save up a decent down payment, you will be well on your way to qualifying for the home of your dreams.
Summing Up Mortgage Overlays
As you can see, with the varying scenarios and rules instituted by each lender, it can be a bit confusing for people to get a home loan. This is the main reason why you should understand the importance of the difference between a mortgage pre-approval vs pre-qualification. When you get pre-approved, if any of the mortgage overlays apply to your situation, your loan officer can inform you about it up front so that you can be prepared. That makes the whole loan process much easier and will ensure you get the right loan for your personal needs.
- Important Disclosure
The VA mortgage program is available to eligible Veterans only.
For all USDA mortgage loans, property and income restrictions apply.
Additional Mortgage Resources:
Top Ten Mistakes Home Buyers Make via Debbie Drummond
How to Avoid Overpaying For a Mortgage via Bill Gassett
First Time Home Buyer Tips via Anita Clark
Costs of Buying a Home – Now and Later via Greg Hancock
6 Ways To Buy A Home With Little Or No Money via Kyle Hiscock