What Are The FHA Compensating Factors?
Kevin Graham5-minute read
March 31, 2023
When you're trying to qualify for a mortgage, there are many moving pieces lenders take into account including your credit score, how much debt you have, the regularity of your income and your savings. If any of these is out of whack, there's the potential that you have to work on it before you can be approved.
However, there are times when life happens. Maybe you ran up some debt in college, but you’re working on it, and you have some savings. Maybe you have credit history with a couple of dings, but you have plenty of income and steady employment. You may still be able to qualify for a Federal Housing Administration (FHA) loan. These are called FHA compensating factors, and we’ll discuss them in detail.
What Is A Compensating Factor And When Are They Needed?
The best way to think of a compensating factor is as a point in your favor that looks good to an underwriter, the person making an evaluation of whether you qualify for the mortgage. These compensating factors make up for the fact that you may have some work to do in other areas.
As an example, a borrower who has a low credit score, low income or a high debt-to-income ratio (DTI) may be able to make up for this by having strong compensating factors in other areas of their application.
Before getting into compensating factors, we should go over some of the basic guidelines for getting an FHA loan. You need a median credit score of at least 500. To qualify with a score that’s this low, you need a 10% down payment or equity amount.
However, it’s worth noting that lenders set their own policies. Most lenders, including Rocket Mortgage®, require 3.5% down with a 580 FICO® Score.
In many cases, loans can go through an automated approval system. If the computer determines based on the information gathered that you present an acceptable risk to the FHA, you can move forward.
If your application is rejected by the system, a lender may still be able to manually underwrite your loan. The FHA has strict limits on the amount of your gross monthly income that can go to your mortgage payment and your overall DTI. For example, to qualify with a credit score of 580 and above under manual underwriting, you may have to have a mortgage payment that covers no more than 31% of your income and an overall DTI of no more than 43%.
If you have certain compensating factors, your housing expense ratio on a manually underwritten loan can be as high as 40% and your overall DTI as high as 50%, enabling you to qualify with slightly higher monthly payment requirements So the compensating factors can be very important.
Before we go further, it should be noted that each lender sets their own policies based on FHA guidance and their individual risk tolerance. For all manually underwritten FHA loans from Rocket Mortgage, the qualifying credit score must be at least 640. Additionally, your mortgage payment can’t be more than 31% of your gross monthly income and overall DTI can’t exceed 43%.
What Are The Compensating Factors That Are Considered By Lenders For FHA Loans?
There are several compensating factors that are considered by a lender for an FHA loan. We'll run through them next.
Savings And Cash Reserves
When you qualify for a mortgage, lenders often want to see that you have a certain number of months’ worth of mortgage payments, with the idea being that in the event of a loss of income, you could sustain your mortgage payment for a while. This is referred to as having cash reserves.
According to the FHA, it can be considered a compensating factor if you have three mortgage payments in savings when you’re buying up to two units. If you’re buying three or four units, you’ll need 6 months’ worth of mortgage payments.
Reserves are a big part of the reason that mortgage lenders check your assets. They want to know that you have savings available. Under FHA guidance, assets can be anything not used to pay closing costs as long as they aren’t gifts, borrowed or cash received from the mortgage closing.
Your debt-to-income ratio is one of the big things that determines exactly how much you can afford along with your down payment and interest rate. In order to calculate it, you add up your installment and revolving debts and divide it by your gross monthly income. Move the decimal over two places to express the result as a percentage.
The lower your DTI, the better. If you have a very low DTI going into getting a mortgage, you have room for a bigger house payment. However, keeping a low DTI of no more than 36% or so can send a signal that you’re not overextending yourself.
One specifically mentioned the compensating factor according to the FHA is having no discretionary debt. In other words, the only thing that’s not paid off every month is your mortgage payment.
Residual Income And Steady Employment
If you have steady employment, you’ll always have money coming in. Because of this, you’re viewed as more likely able to make your mortgage payment. This is a compensating factor in your favor.
Residual income is defined as the amount of pretax income you have after accounting for personal debts and expenses. If you have a fair amount of money left over at the end of the month, this is viewed positively because you would be able to better handle a decrease in income if you had to.
High Other Income
When applying for a mortgage, a lender is most concerned about the income you receive on a regular basis as part of a salary or hourly rate because that’s something that’s likely to continue moving forward. That doesn’t mean your other income counts for nothing.
If you have a high level of income from any of the following categories that you’ve received in the past, it could help your chances to qualify:
- Part-time work
- Seasonal income
Larger Down Payment
Although not specifically listed as a compensating factor by the FHA, having a larger down payment makes you less of a risk for a lender. This is because your monthly payment is relatively lower than someone who makes less of a down payment.
You also are often considered less likely to default because you’ve made a large upfront investment. You’ll keep up with the payment because you don’t want to lose what’s been put in already.
Good Credit History
This is not specifically listed as a compensating factor, but if you have a higher credit score, lenders and the FHA will often allow you to qualify with a higher DTI ratio, especially if approved through the automated underwriting system that the FHA has.
In addition to your down payment, your credit score is a key thing that influences your interest rate. In general, the higher your score, the better.
The reasoning for this is that a good credit history shows the lender that you’re more likely to make your monthly mortgage payments. In addition to the score itself, they’ll look at what’s shown on your credit report. If it’s clear of things like late payments and collections, all the better.
The Bottom Line
If you’re on the edge of qualifying or not for an FHA loan, compensating factors can help you get approved. You might be particularly benefited by them if you have a lower credit score or need to qualify with slightly higher debt.
See What You Qualify For
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