You've reviewed the requirements for the type of mortgage you want. You've made sure you have the credit score, down payment and debt-to-income ratio (DTI) the loan requires. So why has your loan application been rejected?

Stricter requirements called lender overlays are at fault. Lenders overlays are the rules of individual mortgage brokers and banks that are stricter than the rules that government entities establish for various mortgage products.

Lender overlays also come in the form of stricter documentation requirements, such as having to submit much more paperwork (e.g., bank statements) for an FHA Streamline refinance, than the FHA itself requires. Paperwork that doesn't pass muster can also result in unexpected rejections. Lender overlays affect refinances, too.

This article first details what lender overlays are. It then explains how you, as a borrower, can improve your chances of getting a mortgage despite lender overlays.

Minimum Borrower Criteria for Mortgage Qualification
The minimum criteria you must meet to obtain a mortgage depend on the type of mortgage you're applying for. For most mortgages, Fannie Mae and Freddie Mac set the guidelines, because these two entities buy a significant percentage of mortgages from the lenders and brokers that originate them. For an FHA mortgage, the Department of Housing and Urban Development (HUD) establishes these criteria because the government pays lenders when borrowers default on these loans. Similarly, the Department of Veteran's Affairs guarantees and sets the minimum borrower qualifications for VA loans.

Lender Overlays: The Basics
While Fannie Mae, Freddie Mac, HUD and the VA establish minimum borrower criteria, they do not actually issue mortgages: lenders do. Because lenders have to protect their own financial interests, they may choose to use stricter lending criteria if they don't feel the minimum standards are high enough.

For example, while the FHA might require a minimum FICO score of 580 to qualify for FHA's 3.5% down payment program, a lender might have learned from its own experience that FHA borrowers with credit scores below 640 are more likely to default, so it will only extend FHA loans to borrowers with at least that credit score. Even though the FHA insures the loan, lenders still want to avoid costly foreclosures.

Lenders also impose overlays to reduce the risk that they will be forced to buy back a mortgage they have sold to Fannie or Freddie. Fannie and Freddie can force a buyback if a lender fails to follow these entities' lending guidelines. Post housing crisis, these forced buybacks, also called "put backs" or "repurchases," caused major problems for lenders. Lenders, in turn, became more cautious in issuing mortgages.

How Marginal Borrowers Can Get Approved Despite Overlays
If you're at the margin of the minimum requirements specified by Fannie, Freddie, HUD or the VA, any additional requirements imposed by a lender will likely mean that you won't qualify for a mortgage. So how do you find a lender who doesn't have overlays?

"Lenders typically don't broadly advertise their use of overlays, or in reverse, their lack of overlays," says Scott Fletcher, EVP of underwriting and credit policy at Fairway Independent Mortgage Corp. in New Berlin, Wis. "In some cases, borrowers can review lender guidelines online at the lender's web page. However, in many cases this type of research will require talking to an employee of the lender, in depth, about [their] specific situation and whether the lender has mortgage programs that will fit [their] needs."

Amy Tierce, regional VP of Fairway's Needham, Mass. branch, says it can be very hard for a consumer to figure out whether a lender uses overlays. She says borrowers should start with a referral to a lender who will thoroughly review the borrower's financial profile. If that lender can't approve the loan, it should be able to refer another competent lender who can.

Lender overlays don't just add more restrictive underwriting guidelines, she says. They also affect interest rates, with each overlay accompanying a rate adjustment. "The lenders who remove the overlays on underwriting will generally still have the pricing increases built into the rates," she says.

"Most loan officers do not know that their [company uses] overlays or that each lender can do something different," says mortgage broker Todd Huettner of Huettner Capital in Denver, Colo. "The differences can be huge. This is part of the reason why so many people are denied a loan when they really can qualify. They just don't meet the requirements of a specific lender, but may be just fine with another," he says.

If borrowers can find a lender who sells directly to Fannie or Freddie, they might be able to avoid the overlays that big banks may have. It is tough to find such lenders, says Dean Vlamis, vice president of residential lending with PERL Mortgage in Chicago. If a borrower came to him with credit score or debt-to-income ratio challenges, he could look for an end lender who didn't have overlays that would prevent the borrower from qualifying. He has this flexibility because PERL is a correspondent lender, meaning they underwrite and fund loans, then sell them after closing.

"The bottom line is that most lenders only have one option, so you are out of luck if you do not meet their overlays," says Huettner. Consumers don't know, and loan officers usually don't know or won't tell you, if another lender will approve your loan. Working with a broker gives you access to a variety of lenders and possibly more options.

Lender Overlays and Changing Market Conditions
Lender overlays aren't set in stone; they change as economic conditions and housing market conditions shift.

"Lenders will adjust their underwriting standards, including overlays, in response to many things," says Fletcher. "Changes in the housing market, investor appetite, the regulatory environment, market forces (competition) and risk tolerance, among others, will cause lenders to continually evaluate their standards," he says.

The obvious reason for banks to ease their overlays is money, Vlamis says. "If they want to increase their mortgage business, they can simply ease their guidelines, thus making it easier for more people to borrow," he says.

Tierce says that when lenders are more confident about the economy and less fearful of declining home values and potential foreclosures, overlays can ease up.

The tendency for overlays to change from time to time means that waiting may eventually allow you to qualify. Keep your finances in order in the meantime.

The Bottom Line
Overlays generally hurt borrowers who have a potentially higher risk of default because of credit issues or a limited down payment, says Vlamis.

As frustrating as it can be to get rejected, borrowers can use the experience as a starting point to make changes - such as cleaning up credit and saving more for a down payment - that will allow them to qualify for a mortgage in the future.

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