Compensating Factors For Credit Challenged Borrowers
Compensating Factors For Credit Challenged Borrowers
In Non-QM lending, the philosophy is to adopt a commonsense approach, weighing various financial factors—often called the “four C’s of Credit” (Cash/liquidity, Capacity/ability to manage debt, Credit/history of repayment, and Collateral/property secured)—to ensure the borrower has both the willingness and ability to repay the loan. As such Non-QM Loans allow underwriters to consider compensating factors for credit challenged borrowers.
The Role of Compensating Factors in Non-QM Lending
Compensating factors are documented strengths in a borrower’s financial profile that offset a weakness or risk elsewhere in the application, such as higher Debt-to-Income (DTI) ratios, recent derogatory credit events, or reliance on alternative income documentation.
- Enabling Exceptions: Exceptions to published guidelines are considered on a case-by-case basis when compensating factors exist to offset the risk. Loans requesting exceptions should exhibit strong documented compensating factors. Typically, a loan exhibiting a credit underwriting exception should have at least two compensating factors that are not related to the specific exception itself.
- Balancing Risk: Lenders commonly offset perceived risk by focusing on borrowers with higher credit scores and lower Loan-to-Value (LTV) ratios. This balances risks associated with high DTI ratios, limited documentation, or unique features like interest-only payments.
Categories of Compensating Factors
Compensating factors generally fall into categories relating to the borrower’s liquidity/capacity and their historical stability/performance.
A. Financial Strength and Liquidity (Cash & Capacity)
Factors demonstrating a borrower possesses ample financial capacity and reserves beyond minimum requirements are highly valued:
- Reserves/Assets: Having reserves well above the program minimum is a key compensating factor. This is quantified as PITI(A) reserves above minimum by 6 months or higher.
- Debt-to-Income (DTI) Ratio: A DTI ratio that is well below the program maximum, typically quantified as DTI below max by 5% or greater, provides a strong offset to risk.
- Disposable Income: Demonstrating significant gross disposable income is a top compensating factor, as is an increase in residual income by 10% or greater or residual income that is $1,000 above the program minimum required.
- Payment Reduction: A reduction in housing payment by 10% or greater compared to the prior obligation is considered a compensating factor.
- Payment Shock: Maintaining minimal payment shock (the difference between the old and new housing payments) is a stabilizing factor.
B. Stability and Performance History (Credit & Character)
Factors that illustrate a stable employment history and consistent repayment behavior are strong compensating factors:
- Credit Score: A FICO score above the program minimum by 20 points or higher is a documented compensating factor. A score well above the minimum suggests solid performance despite any minor derogatory events.
- Housing History: Demonstrating a perfect long-term housing payment history is critical, generally documented as 0 x 30 x 24-month housing history (no 30-day late payments in the last 24 months).
- Job Stability: Long-term employment indicates reliable future capacity to repay the debt. This is typically measured as job stability of 5 years or more or having significant time on the same job.
- Credit History Depth: A lengthy and deep credit history of solid performance and a demonstrated capacity to carry a heavy debt load with on time performance are strong compensating factors.
Investor-Specific Compensating Factors
For loans secured by investment properties (DSCR loans), compensating factors often relate to the quality of the asset and the experience of the borrower:
- Debt Service Coverage Ratio (DSCR): For investor loans, a DSCR above minimum by 0.15 or higher is a significant compensating factor. Similarly, a DSCR Ratio above 1.15% is noted as a top factor for exception consideration in the Horizon series.
- LTV/Collateral: While LTV is explicitly stated as not a compensating factor for a primary residence in the Edge series, it is recognized as a factor for investment loans. An LTV below max by 5% or higher is a DSCR compensating factor.
- Investor Experience: Being an experienced investor (defined as having greater than 3 current rental properties) is a compensating factor for DSCR loans.
FAQ's
A loan that exhibits a credit underwriting exception should typically have at least two compensating factors that are unrelated to the specific exception itself.
Having a Residual income $1,000 above the program minimum required is a strong compensating factor.
A Debt Service Coverage Ratio (DSCR) that is above the program minimum by 0.15 or higher is a specific compensating factor for investor loans.
A reduction in housing payment by 10% or greater compared to the prior obligation is considered a compensating factor.
Job stability of five years or more is listed as a compensating factor that suggests a reliable future capacity to repay debt.
A clean history known as 0 x 30 x 24-month housing history (no 30-day late payments in the last 24 months) is a noted compensating factor.
A DTI ratio that is below the program maximum by 5 percentage points or greater is considered a strong compensating factor.
Having PITI(A) reserves above the program minimum by six months or higher is a documented compensating factor, demonstrating strong liquidity.
A FICO score that is above the program minimum by 20 points or higher is recognized as a compensating factor.
Compensating factors are documented strengths in a borrower’s financial profile used to offset or mitigate risks associated with a specific weakness or exception in the loan application.
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