What Are Compensating Factors?

So, you’re interested in getting a mortgage, but you know for a fact that you’re anything but an ideal candidate. You’ve resigned yourself to a life of renting and living under other people’s rules, because there’s no way you’re going to get your debt-to-income ratio into an ideal place and there’s not a house to be had within your ideal price range. Your income has changed, you changed jobs, your small business is taking off and you want to pursue that full time — the list of reasons you can’t get a mortgage is mounting. Or are they?

As it turns out, getting a mortgage isn’t as straightforward as many lenders would like you to believe. Sure, there are rules for extending this much credit, but you should think of them more as suggestions. They’re in place to ensure that banks can sell these notes to other parties, such as Fannie Mae, but they’re only a starting point. There’s another concept that comes into play when you’re not a perfect All-American applicant: Compensating Factors.

What are Compensating Factors?

When you need a mortgage, but you’re not a perfect risk, your underwriters can build a case as to why you will still be a responsible mortgage holder using something they call “compensating factors.” These are, as the name implies, factors that they believe compensate for your shortcomings. So, if your credit score is a little low or your debt-to-income is a little high, these compensating factors could level the playing field for you. Keep in mind that a really awful credit score and out of control debt won’t be cured by compensating factors, they’re simply tools for people who are so close to being approved that they can almost touch it.

Every type of loan, and even sometimes different lenders, have exact ideas as to what compensating factors weigh the most and even what compensating factors they’ll accept. These are a few of the most common you’ll come across:

Cash. This probably comes as no shock, but the more money you have to put down, the less of a risk you pose and the more likely you are to get an approval. So, let’s say you’re pursuing an FHA loan with a minimum 3.5 percent down payment, but your credit is so-so. Depending on just how bad your score is and what’s causing it to be troubled (if it’s medical, especially, you’re usually gold), you can sometimes secure an approval with a 10 percent down. In this case, you may be asked to pay off certain debts or judgements to ensure that your home won’t have a lien filed against it.

Savings. When your credit’s free of defects, but there’s something else troubling about you — for us, it was owning another house already — your savings can help a bunch. Banks refer to long-term savings as “reserves” and will count them in your favor, especially if they’re substantial. Your 401k is one of the best places to look for reserve money, since it’s both semi-liquid and easy for banks to verify the source of the money contained therein.

Credit Score. A super high credit score is a no-brainer for lenders. Provided you meet the minimum requirements for a loan program, something else in your profile can be a bit problematic and you’ll still likely see an approval. For example, Fannie Mae will only allow the stretch debt-to-income ratio of 45 percent if your credit score is over 640 (with an LTV under 75 percent). If you have a score of 700 or greater, the Fannie Mae guidelines allow that stretch DTI with an LTV up to 95 percent, which is pretty awesome.

Debt to income ratio. By now we all know what a DTI is, but lenders hyperfocus on this figure because it can tell them how indebted you are and how likely that will cause you to default on your mortgage. Although people tend to take care of their mortgages to the bitter end since they need somewhere to live, massive repair bills can be another cause of default when the example homeowner is already swimming in debt. So, if your debt is within the bank and program’s idea of reasonable, or even well below their lowest risk tier, so much the better. If your credit score’s a bit shaky or you don’t have an ultra large down payment, you still might not have any problems with an approval your DTI is very low.

Loan Type. Your loan type actually matters, too. ARMs, for example, are so much more risky for lenders than 30-year fixed notes that they’ll often make approvals easier for the safer products. Since there’s no way to know where your interest rate will be in the next few years, those ARMs are terrifying, which means you’d better be a good loan candidate in other ways. When other adjustable mortgage products were on the market, only the best buyers could get them (and ended up defaulting on them anyway). In the end, it’s all about risk.

Compensating Factors Can’t Fix Everything

No discussion on this topic is complete without making it absolutely clear that compensating factors can’t fix everything. If your credit is really wrecked or you’re in deep debt or you have absolutely no savings, you shouldn’t be buying a house today. Honestly, in most cases, relying on being saved by compensating factors alone is probably not the best financial move, but sometimes we have no option but to cash out our savings and take the plunge, for whatever reason.

Maybe you’ve been relocated and you’re trying to buy a new home far away or perhaps you’re trying to take over the loan on your parents’ home unexpectedly — there’s always an exception. But if you have an option, if you can wait and straighten things up, then you should, both for the easier loan approval and for your long-term financial health.

These three items should be on your list if you’re not in a rush to buy a house:

Credit. Your credit is the ultimate insurmountable problem. If your score is low, you have judgements against you or have had a recent bankruptcy or foreclosure, no one will loan you a red cent. You’ll have to start doing better today and then work on some of the backlog. So, make payments on time, renegotiate terms on loans you’re struggling to pay, ask for help from your lenders to get back on track. Don’t miss any more payments. Deal with judgements, but leave all the other stuff alone (trust me with this). Track your credit using a highly accurate tool like MyFICO, the credit tracking your credit card offers is not even remotely the same (I’ve been watching them all for a year and the differences are alarming).

It may take a year or two years of better credit habits, but you’ll get what you give. In 2011 and 2012, I had a divorce and over a quarter million dollars worth of surgery, I lost everything and my credit was trashed for my efforts. In early 2013, I sat down and was determined to fix this mess, and all I did was what I’ve outlined above. I couldn’t get a credit card in 2012, but I got a car loan just a few months ago and it was the easiest thing I’ve ever done. When we bought this house in 2015, our lender told me that he could have gotten me on the loan as a secondary borrower if I had wanted it. There’s no magic trick to repairing your credit, just slow and determined effort.

DTI. Like your credit score, your DTI is one of those things that you’ll improve bit by bit. Ideally, you want it to pay everything off, then use your credit lines regularly while paying the balance each month. That’s not always possible, I know, but as long as your debt is less than about 15 percent of your income, you’ve got a lot of room to wiggle. This will vary, though, because some areas may require that you max out your DTI just to buy a small condo — so keep this in mind and pay everything down as much as you can before applying for a mortgage.

Savings. Having a healthy savings account always looks better than coming to a lender with absolutely nothing in hand. That being said, this savings account could also be a fully-vested retirement account that allows you to borrow or cash out for a home purchase, so we’re not necessarily talking about CDs and bonds. Sock money away anywhere you can and put more back than you’ll need to close — the more you can save, the better, of course. Savings are less important than the other two factors above, but they’re not nothing. You still have to pay your closing fees and the lender will verify that you can.

The Bottom Line: Compensating Factors Are Helpful, But Aren’t Everything

Compensating factors are a great way to push an almost ready to buy buyer into the able to buy category if the need is there, but they’re not a solution for everything. If you can wait, if you can correct your credit deficits, improve your DTI and build your savings, you’re going to be a lot better mortgage candidate.

With rates continuing to creep up, the argument could be made for both waiting to buy until you’re really ready and buying now before they get higher, but I firmly believe that any homeowner who leaps before they look is taking a massive gamble with their future. If your house ever needs a major, unexpected repair, having a savings account and a low amount of credit debt means that you’ll be able to respond quickly, before the problem becomes incurable and the house uninhabitable.