Lenders have guidelines you must meet in order to obtain an approval. However, sometimes they are able to grant exceptions for things like a high debt ratio or low credit score when you have compensating factors.
What are Compensating Factors?
Compensating factors are things that go above and beyond the lender’s guidelines that help increase the strength of your credit profile. Lenders look at them as a way to offset negative factors. It’s a way to overcome a financial weakness – something that tells the lender that you are a strong candidate besides that one weakness.
These positive factors most often overcome low credit scores, poor credit history, and high debt ratios. These factors can usually shoot a mortgage approval down. A low credit score and/or high debt ratio shows financial irresponsibility.
Two Weaknesses Can’t be Overcome
Don’t mistake this as an excuse to have both bad credit and a high debt ratio and still get approved. That’s next to impossible. Lenders look at applications with both of those negative factors as much too risk. Two financial irresponsible factors are too much for any lender to handle.
Compensating factors are meant to overcome one weakness, while helping to make the other positives in your financial profile even more positive. Chances are, though, if you have two weaknesses, such as a bad credit score and a high debt ratio, you wouldn’t have any compensating factors to fall back on anyways.
The Top Compensating Factors
There are many compensating factors you can have, but these are the top factors that make lenders rethink their potential denial.
Money on Hand
There are many ways you can use excess money on hand. You can make a larger down payment than the program requires. You can also keep the money in your savings account or another liquid investment vehicle as reserves. Either way, you offset the lender’s risk.
A large down payment gives you ‘skin in the game.’ You are now more motivated to make your payments on time no matter what it takes. Let’s take the minimum 5% conventional down payment for example. You can put just 5% down, but then you borrow 95% of the home’s price. That puts the lender at a disadvantage. But, if you put down 20%, you are more motivated to find a way to make ends meet. The lender only has to lend you 80% and has more confidence that you’ll make your payments.
Reserves help you should your income suddenly stop. It’s a way to reassure the lender that you can keep going with your mortgage payments no matter what happens in the future. It’s a way to protect against financial insecurity, which everyone faces in today’s uncertain world.
Low Amount of Debts
We talked a lot about debt ratios above and that’s because they play a crucial role in your mortgage approval. If you have few debts aside from the mortgage, you could use that as a compensating factor. Lenders like to see that you are not spread thin. Again, it helps reassure them that you’ll be able to get that mortgage payment paid.
The conventional guidelines require a total debt ratio no higher than 36%. Use that as your guideline for any program. If you can have a debt ratio at 36% or lower, you could be in good shape to use it as a backup factor to help you gain mortgage approval.
Again, your credit score plays a very important role in your ability to secure a loan. It’s one of the first things lenders look at to decide what to do. But, if you have exceptional credit, it could work in your favor even more. Not only will you get a mortgage approval, but you can use that higher score to offset things like a low down payment or high debt ratio. Showing a strong history of paying your bills on time and not stretching yourself thin speaks volumes with lenders.
A Bright Future
Young mortgage applicants often start off with a low salary. However, if you have great earnings potential based on your degree earned and chosen industry, you’ll be in good hands. Lenders can look at you as a good risk, knowing the average salary in your industry. This works well for those that went to school to be a doctor, lawyer, scientist, or any other high profile field.
Proving Your Compensating Factors
Now here’s the catch. You can’t just assume a lender will notice your compensating factors. You have to prove them to the lender. Talk to the lender about that during your first conversation. Let them know that what they see on the cover isn’t the only factors that you have going for you.
Even before you apply for the mortgage, start gathering your proof of these factors. Lenders need at least the last two months’ of bank statements or investment statements for proof of your large down payment or asset reserves. Some lenders may require as much as the last 12 months’ of statements, though, so be prepared.
If you have a promising career ahead, have proof of your degree and intended career path available. You can even gather research from your college of study showing the potential salary you’ll make as you gain experience and move up in your chosen field.
Obviously a high credit score or low debt ratio is something the lender will see upon normal processing of your application. But, it’s worth mentioning these factors just to highlight them and get yourself noticed as a good applicant.
Compensating factors can make the difference between a denied loan and an approved one. We recommend that you start early. Even as much as a couple of years before you apply for a loan can help you best prepare your financial profile for a loan approval.