Did you know that lenders can add requirements to the actual loan program’s requirements? It’s called lender overlays and it’s common for FHA, VA, USDA, and conventional loans. The lender is the one that takes the risk with the loan. They underwrite and fund the loan. Sometimes they tighten up the restrictions to reduce the risk of default.
What do Lenders Require?
As you shop around, you’ll find that each lender has different requirements. For example, one lender may accept a 580 credit score for an FHA loan (that’s the FHA’s minimum credit score), but another may want a 620 score. That’s an example of a lender overlay.
The most common lender overlays include:
Credit score overlays
Lenders like to see higher credit scores. It reduces the risk of default because people with higher credit scores generally pay their bills on time. If you have a borderline credit score, just meeting the loan program’s requirements, you’ll need a lender that doesn’t require higher scores. Keep in mind that credit scores often dictate your interest rate (low scores get higher rates) and may also dictate the amount of down payment you need (low credit scores may require higher down payments).
Down payment overlays
Each loan program has its minimum down payment requirements. FHA loans require a 3.5% down payment and conventional loans require a 5% down payment. Both USDA and VA loans don’t require a down payment. Some lenders, however, require higher down payments than the stated minimums.
Each loan program also has debt-to-income ratio requirements. FHA, VA, and USDA loans have rather flexible guidelines, which some lenders like to tighten. For example, FHA loans allow a 31% housing ratio and 41% total debt ratio. If you have a borderline credit score, lenders may tighten up these DTI requirements to lower the risk of default.
Avoiding Lender Overlays
So how do you find a lender that doesn’t require overlays, especially on loans like the FHA or VA loan? You will need to shop around. We always suggest that you get quotes from at least three lenders when looking for a loan. This way you know not only what each lender charges, but also what overlays they require.
As you shop around ask lenders:
- What requirements they have that differ from the standard guidelines
- How your qualifications may affect their approval, especially if you have a low credit score or high debt ratio
- How they think you stack up to the lender’s requirements
You can ask these questions before allowing the lender to pull your credit. If you are honest with lenders upfront, letting them know about your credit history, the amount of your down payment, or your debt ratio, they can tell you what they think. Experienced loan officers know the guidelines and they know what lenders will allow to slip through the cracks and where they may be a little tougher.
If you don’t want the hassle of shopping around and asking multiple lenders questions, you can use a mortgage broker too. Mortgage brokers have access to many lenders, sometimes hundreds of them. If you use an experienced broker, he or she will know which lenders will approve you for the loan, giving you the best chance of avoiding lender overlays in certain situations.
Keep in mind that most lenders use what they call risk-based pricing. This pertains to your interest rate. If you do find a lender that doesn’t have lender overlays, they may make up for the risk of default that you pose with a higher interest rate.
Charging interest is how lenders make money on your loan. It’s also how they offset your risk of default. If you are a high risk of default, lenders often charge more for the loan. This way they know they’ll make money while you are making payments. If you default, they at least made the extra money on the higher interest rate they charged you.
It’s important to know your situation and be honest with lenders from the start. Let them know what you have going on and let them tell you how it may affect your approval status. If you start early, getting pre-approved with several lenders, you’ll know what you need to do to fix your situation or what rates you may have to pay to make up for your risk of default. There are many lenders out there that don’t have lender overlays – you just have to shop around to find them.