Onions are not the only thing with Layers!

I was sitting on my couch the other day watching one of the most infamous movies of all time with my children. The movie I am certain that many of you remember. During the movie there is a point when they talk about how “Onions have layers” and it got me thinking. Yes, that movie was Shrek and no this is not a pitch for the upcoming Shrek 4.

Like onions, all mortgage loans have layers. The layers are risk layers. Every file that we touch or work on is evaluated by the amount of risk to the investor. Risk is evaluated on several different ways. An underwriter has to be comfortable with the level of risk in order to approve the file. These layers can be described the following way: 1) Credit 2) Collateral 3) Capacity and 4) Compensating Factors.

Credit – Credit is more than a score. The score does make up the first level of assessment. If you do not have a score that meets the minimum requirement for the program you are done before you begin. However, what if you do have a score that is high enough to qualify for the loan program. Does that mean it is a done deal at that point? Credit has several components that we must go over to make sure that a consumer not only meets the requirement for score but credit as well. Some of these factors are:

• # of trade lines open and rating current – A trade line is an open account such as a credit card, and auto loan, a mortgage note, and installment debt or even a lease. These trade lines must remain open and most be rated to the current date. Some people have old credit cards that they never actively closed that have not reported in months. This shows the lender that you have the ability to open and maintain credit and when you have done so for several different types of credit it will help establish a solid score. They do go hand and hand. However if you have a 700 score and only one open trade line that is a small credit card open for 5 months this will not qualify. Although the score is high there has been little time for you to make a mistake and the low limit is a low risk for the credit card company. This would be insufficient credit.
• Several Open Collections – FHA specifically looks at the last twelve months of credit to see how you are doing now. There are cases that the scores are qualifying scores but a client has many open collections for semi large amounts. If this is not in the last twelve months the underwriter might require them to be paid especially anything over $1000 or so. If they are in the last twelve months and there is more than one you most likely will not qualify for the loan. If it is only one then you will have to write a suitable explanation and it will be left to the underwriters judgment. The only exception to this rule is Medical collections.
• Open Tax Liens or Judgments – Any of these items will have to be paid no matter what. They will also be further evaluated to see when they occurred what it is and why. Remember they are trying to see if there is any recurring behavior patterns of unpaid debts without explanations that make sense or situations you could not have predicted.

Collateral – is based on how much you are putting down on the property you are buying or the amount of equity you have in your current home. The larger the down payment the lower the risk. Anything less than 20% down requires Mortgage Insurance. Mortgage Insurance is designed to cover the investor on their losses in the even that the consumer forecloses. FHA is a Government insured loan and is designed to have a limited down payment so generally the collateral portion for FHA borrowers is usually not considered a strength of the file as a whole.

Capacity – This is the consumers ability to repay the debt. This is largely based on your debt to income ratio. However, capacity can be broken down further and commonly is:

• Time on the Job – If you are in a new industry where you get tips, overtime, bonus, commission or any other special compensation that you did not receive at your previous job they may not include this income. This could have a dramatic impact on the qualifications.
• Work History – I have had situations where the borrower had many jobs and this spooked the investor. I had to make up for spotty job history but accenting the positive factors of the loan.
• Self Employed Income Decreasing Year over Year – many loan officers take a two year average and that is the way that we are taught if and only if the income is steady and or increasing. In the event the income is decreasing year over year we use the current year only and we must make sure that the decline is not severe.

There are other items on capacity that we may look at in the layering of the risk but for time and length purposes that is all that we will discuss here.

Compensating Factors -Any factors that decrease the layers or levels of risk in the file. Some compensating factors may include but are not limited to:

• Assets
• 401K
  
• Long time on same job
• Reserves after down payment (not an FHA Requirement but considered a compensating factor)
• Low Debt to Income
• own funds to close not gift

The following Illustration is one that I have always used to give myself a visual of all the information above. Then I would rate each section 1-10 and determine how to present the strengths and minimize the exposure of the weaknesses.

Although overly simplified the graph shows that Credit, Collateral and Capacity are the focal points or base of the triangle. If any one of them are not very strong it is up to the supporting arms or Compensating factors to make up the difference. In order to do so the compensating factors have to make sense and be supportive to the overall structure of the file.

Ultimately the layers of risk will make or break your file. The goal of a loan officer should be to package the file in the best manner possible to make sure the underwriter sees why this is a good file. If someone has a high debt to income (Capacity) then it is essential that they are strong in credit and collateral and it is a bonus if they have compensating factors such as reserves. When borrowers want to do down payment assistance programs they are adding layers to the file. When you increase the layers or levels of risk you create a greater chance for error or decline. It is imperative that as you increase the risk you have supporting compensating factors that help to justify the risk an investor may take on you. As a consumer you can work toward this. Set yourself up for success. Decrease the layers that your file has and maximize your three C’s. This will help you to get a loan in today’s economy.

In conclusion, it is all about risk or layers. You want to give as many reasons to the investor to buy your loan as you can. I understand that it is hard to fire on all cylinders all the time and that is why Compensating factors play a huge roll. If you know that you have lower credit, don’t make a ton of money, and have limited down payment then you have to understand that you may be asked for several items. If you want to ask for down payment assistance you have to take a step back and be the investor. The question is why do I want to give my money to this person? Our job is to assist you in answering that question for the investor.

As always thank you for reading.