Written By: Stacey Sprain, Op-Ed Writer
In today’s world of FHA underwriting, I think it can be said that we cannot assume that an automated underwriting establishes a positive credit risk. AUS approvals are really unreliable in today’s marketplace. Quite frankly, I consider them pretty much worthless. Manual underwriting is a much more sensible approach to analyzing credit risks and rendering loan decisions and the more documentation included in the loan file, the better the chance of catching any risk factors that might have otherwise escaped an automated underwriting system. Often we seem to forget that an AUS simply does not have the capabilities to analyze credit risks in the same manner that an actual underwriting body does.
The bottom line is that overall, credit risk factors haven’t changed. The same credit risks exist today that have existed for many years. It’s just that until the real estate markets tumbled, many of the risk factors were ignored or were simply considered with much less validity than they are today. The automated underwriting systems are still trying to catch up.
Below I have identified a number of standard credit risk factors along with helpful instruction on how to go about analyzing each individual risk mentioned. A standard rule of thumb is that each risk factor should be offset by a recognized compensating factor. I have included a listing of HUD-recognized compensating factors below as well.
CREDIT RISK FACTORS AND SUGGESTED ANALYSIS
Credit Risk Factor - Housing expense ratio is greater than 31%
Even if AUS doesn’t require, it’s wise to obtain a VOR to verify the current housing expense and payment history. The borrower’s housing expense payment history to date is an important factor for analyzing whether or not a housing ratio greater than 31% is a huge concern or not.
Does the borrower have a history of paying a housing expense at the same or near the same amount as the proposed housing expense?
Does the borrower have reserves that demonstrate the borrower can sensibly dedicate a greater portion of earnings to the housing expense while still being able to save money in case of hardship or emergency?
If there is a substantial increase to proposed versus current housing expense, it’s wise to obtain an explanation letter from the borrower explaining how the borrower intends to accommodate the major increase to housing expense. These are often referred to as “budget letters.” An important note- Make sure the explanation letter is signed and dated by the borrower so that you can feel reasonably comfortable that the letter DID come from the borrower and not from a loan officer or processor who simply want to get the condition cleared.
If the housing expense ratio is higher than standard, what about the total debt-to-income ratio? Is that ratio over the standard 43% guideline as well?
Is there a compensating factor to offset the risk associated with this identified risk factor?
Credit Risk Factor - Debt-to-Income Ratio is greater than 43%
It’s important in these situations to analyze a number of factors in order to determine how high of a risk factor the above standard DTI really is for the loan.
1. Does the borrower have a history of successfully carrying this much debt and housing expense or does the proposed housing expense reflect a substantial increase in comparison to the current housing expense? If there is a substantial increase proposed, it’s wise to obtain an explanation letter from the borrower explaining how the borrower intends to accommodate the major increase to housing expense. These are often referred to as “budget letters.” An important note- Make sure the explanation letter is signed and dated by the borrower so that you can feel reasonably comfortable that the letter DID come from the borrower and not from a loan officer or processor who simply want to get the condition cleared.
2. Review the borrower’s credit report, Do the fico scores and reported tradelines reflect responsible use of credit or is an abuse or overuse of credit reflected? Are payment histories reflected satisfactorily? Does the borrower have any newly opened debts with very short reporting periods to date which add to the concern for long-term debt management?
3. Are there late payments, unpaid collections, charge offs, judgments or tax liens reflected in the most recent 24 month period? If so, the concern for a higher-than-standard debt-to-income ratio becomes greater. Does the borrower’s history reflect that these derogatories were all reported during the same period or are they reported sporadically? Even if AUS does not address the derogatories, it is wise to seek an explanation letter in these cases. It may be the only way to lend the most accurate possible analysis to the overall credit risk when the DTI ratio exceeds the standard 43%.
4. Review the borrower’s employment and earnings history. Are earnings stable or steadily increasing? Does the borrower have secure employment? Is there potential for increased earnings or pay increases in the near future? Are there any gaps reflected between job changes? Are all job changes for related fields? If stability of employment or earnings is in question, the risk of DTI is much greater than when employment and earnings are clearly stable.
5. For borderline cases where ratios are near 50% and often over, it’s sometimes helpful to figure out exactly what the borrower’s residual income is, the way that VA lending requires. This gives a more accurate indication of exactly how high the risk really is. Use net income and subtract expenses such as the proposed housing expense, all debts in repayment, estimated daycare expense, HOA dues, .14 per square foot of subject property for utilities, any child support or alimony payments and any other long term expenses. What is left for disposable income? Does the remaining income make sense for the family size? Is there enough remaining to accommodate the risk of higher than standard DTI?
Remember- AUS cannot read everything. It’s often helpful to look outside of the AUS findings to identify credit risks that the AUS system simply cannot identify or rectify.
Is there a compensating factor to offset the risk associated with this identified risk factor?
Credit Risk Factor - Borrower is receiving a gift or grant for downpayment and seller is crediting toward all closing costs and prepaids; thus the borrower is not contributing any of own funds to the transaction
Just because the borrower doesn’t need any funds doesn’t mean assets shouldn’t be verified. Again, this is where AUS doesn’t do a good job of analyzing the real risks.
It’s wise to require verification of the borrower’s assets in the form of account statements for a number of reasons.
1. It will allow you to determine whether or not the borrower has the means to contribute the downpayment or costs himself/herself but has simply taken advantage of what current market can offer for deal structuring or if the transaction wouldn’t work without the contributions of other parties.
2. Account statements are a window into the borrower’s spending habits. If there are multiple risk factors within a single loan file and you can tell that a borrower has no regard for spending habits or financial responsibility by review of bank statements, the risk layering becomes of greater concern. Verified assets and reserve funds go a long way to offset a majority of common risk factors within the loan file.
Bottom line, if the borrower gets in trouble, do the assets reflect a likelihood that the borrower can continue to make timely housing payments for at least a month or two under such circumstances. Is there a compensating factor to offset the risk associated with this identified risk factor?
Credit Risk Factor - Lack of Verified Reserves
Review of the borrower’s credit report and current housing versus proposed housing expense are vital when no verified reserves are present.
• Review the borrower’s credit report. Do the fico scores and reported tradelines reflect responsible use of credit or is an abuse or overuse of credit reflected? Are payment histories reflected satisfactorily? Does the borrower have any newly opened debts with very short reporting periods to date which add to the concern for long-term debt management?
• Is the proposed housing expense in the same range as the current housing expense or is there a substantial increase proposed? If there is a substantial increase reflected, regardless of AUS findings, it’s wise to obtain an explanation letter from the borrower explaining the intent to accommodate the major increase to housing expense. These are often referred to as “budget letters.” An important note- Make sure the explanation letter is signed and dated by the borrower so that you can feel reasonably comfortable that the letter DID come from the borrower and not from a loan officer or processor who simply want to get the condition cleared.
• Based on the borrower’s housing expense history and credit, does it make sense that the borrower can reasonably accommodate the proposed housing expense while lacking the ability to save money?
• Are there other compensating factors that offset such risk when a lack of reserves is present?
Credit Risk Factor - Credit reflects unpaid collections, charge-offs, miscellaneous late payments, housing late payments
What’s most important here is the explanation, the time span and the frequency of the derogatory account information.
• Analyze the credit report information. Did all of the derogatories occur in what appears to be an isolated period? Does the report reflect good credit before and after the period of derogatory reportings? If any of the derogatory account reporting occurred in the most recent 24 month period, it’s wise to request a letter from the borrower explaining the reason for the derogatory reportings. The explanation should make sense based on all other file information and it should be completely clear that the borrower has since recovered financially from the situation(s). Derogatory reportings within the most recent 12 month period should have been for reasons beyond the borrower’s control and must be looked at in much more critical manner than older reportings.
• Does the credit report reflect sporadic derogatory account reporting that is not isolated to one particular time period? Does it appear that the borrower’s repayment patterns reflect consistent disregard for financial obligations and potential mis-management of monies? Based on other factors of the file, does the credit report information reflect a high risk borrower who may not be worthy of the mortgage approval?
Again, it is crucial that AUS not be relied upon as the sole source
Credit Risk Factor - Credit reflects consumer credit counseling, prior bankruptcy or foreclosure
What’s most important here is the length of time transpired and the reason:
• the borrower sought the help of credit counseling
• the borrower felt the best option was to file for bankruptcy
• the borrower’s prior home went into foreclosure.
It’s important to recognize what are considered acceptable explanations and what is considered lack of financial responsibility and debt management.
• How much time has transpired since the filing or discharge?
• If a repayment plan was required, were all payments made according to the agreement?
• How was the borrower’s credit history before and after the filing and discharge?
• How is the borrower’s credit history within the past 12-24 months?
• Does it appear that the borrower has re-stabilized financially since the filing or discharge?
• Was the reason something that is very unlikely to occur again in the future?
• Are there other risk factors such as lack of reserves? High ratios? Minimal or no downpayment? These added factors contribute to higher than average credit risks that need to be seriously evaluated for the borrower’s current creditworthiness.
• Are there compensating factors to offset these credit risk concerns?
Credit Risk Factor - Borrower is self-employed
There are a number of questions that must be asked and evaluated when reviewing self-employment:
1. Regardless of AUS documentation requirements, has the borrower been employed or been receiving stable income for the past two years as can be substantiated by no less than two years IRS tax returns and transcripts?
2. Is it reasonable to expect, based on analysis of the employment and income documentation for the past two years, that the income being used for qualifying is expected to continue at or about the same level for the three years following our closing date to justify that our borrower is capable of making timely mortgage payments?
3. Does a review of documentation establish a positive business trend for the self-employment noted?
Additional risk concerns are present whenever the borrower has been self-employed for less than two full years and when two years of tax returns and transcripts are not available for analysis. In addition, declining income trends should also be carefully considered. Most conservative calculations should be used for qualifying income.
Self-employment alone may not be a high risk factor as long as the borrower demonstrates a well-established history in the field and consistent earnings trends with predicted long-term business stability.
HUD RECOGNIZED COMPENSATING FACTORS
Housing Expense Payments
The borrower has successfully demonstrated the ability to pay housing expenses greater than or equal to the proposed monthly housing expenses for the new mortgage over the past 12-24 months.
The borrower makes a large down payment of 10 percent or higher toward the purchase of the property
The borrower has demonstrated
• an ability to accumulate savings, and
• a conservative attitude toward using credit.
Previous Credit History
A borrower's previous credit history shows that he/she has the ability to devote a greater portion of income to housing expenses.
Borrower has additional source(s) of compensating or income not used in qualifying
The borrower receives documented compensation or income that is not reflected in effective income, but directly affects his/her ability to pay the mortgage.
This type of income includes food stamps, and similar public benefits.
There is minimal proposed housing expense increase in comparison to current housing expense
There is only a minimal increase in the borrower's housing expense.
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.
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.
Lenders may use a portion of a borrower's retirement account, subject to the conditions stated below. 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 for conditions other than in connection with the borrower's employment termination, retirement, or death. If withdrawals can only be made under these circumstances, the retirement account may not be included as cash reserves. If any of these funds are also to be used for loan settlement, that amount must be subtracted from the amount included as cash reserves. Similarly, any gift funds that remain in the borrower's account following loan closing, subject to proper documentation, may be considered as cash.
About The Author
Stacey Sprain - As an op-ed writer, Ms. Stacey Sprain is currently a NAMP® Certified Ambassador Loan Processor (NAMP®-CALP). With over 15+ years of mortgage banking experience, Stacey is also a Quality Control Manager for a major mortgage lending institution.