January 3, 2014
When a borrower applies for an FHA home loan, he or she may not fit the “ideal applicant” standard in terms of credit history, credit rating, loan repayment patterns, employment, etc. Sometimes the lender feels that an applicant may be a good credit risk in spite of these things, but needs something to justify approving the loan. Compensating factors can help the lender to do that.
The FHA loan rules found in HUD 4155.1 defines “compensating factors” as things which are used, “to justify approval of mortgage loans with ratios that exceed benchmark guidelines must be recorded on the Underwriter Comments section of Form HUD-92900-LT, FHA Loan Underwriting and Transmittal Summary. Any compensating factor used to justify mortgage approval must also be supported by documentation.”
What can these compensating factors be? A larger down payment, “substantial cash reserves”, income that isn’t counted in “total effective income”, the potential for increased income later down the line, and many other things. All of these can be used to help a borrower who may have a marginal credit score, a debt to income ratio that may be higher than normal, or other ways the FHA loan application may feature ratios above the benchmarks set by the FHA.
There are rules that govern these compensating factors. For example, HUD 4155.1 instructs the lender to carefully consider the nature of substantial cash reserves. “The borrower has substantial documented cash reserves (at least three months worth) after closing. The lender must judge if the substantial cash reserve asset is liquid or readily convertible to cash, and can be done so absent retirement or job termination, when determining if the asset can be included as cash reserves, or cash to close.”
In this particular case, the FHA also has rules on what cannot be counted in the cash reserves. “Funds and/or “assets” that are not to be considered as cash reserves include
• equity in other properties, and
• proceeds from a cash-out refinance.”
When it comes to the potential for increased earnings, FHA loan rules say the lender should take this into account when, “..,The borrower has a potential for increased earnings, as indicated by job training or education in his/her profession.”
FHA loan rules allow borrowers to use retirement account funds as “cash reserves” within certain guidelines.
“The lender may use a portion of a borrower’s retirement account, subject to the following conditions. To account for withdrawal penalties and taxes, only 60% of the vested amount of the account may be used. The lender must document the existence of the account with the most recent depository or brokerage account statement. In addition, evidence must be provided that the retirement account allows for withdrawals under conditions other than in connection with the borrower’s employment termination, retirement, or death.”
Compensating factors may or may not apply on a borrower’s specific application, but it’s a good idea to discuss any possibilities with the loan officer.
Do you have questions about FHA home loans? Ask us in the comments section. You can apply or get pre-approved for an FHA loan at FHA.com, a private company and not a government website.
Joe Wallace has been specializing in military and personal finance topics since 1995. His work has appeared on Air Force Television News, The Pentagon Channel, ABC and a variety of print and online publications. He is a 13-year Air Force veteran and a member of the Air Force Public Affairs Alumni Association. He was Managing editor for www.valoans.com for (8) years and is currently the Associate Editor for FHANewsblog.com.
Browse by Date: