What Are Mortgage Overlays?

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You've worked hard to pay down your debts, improve your credit score and save up a hefty down payment for a new home. So, you apply for a mortgage thinking you'll be approved, only to get denied. Despite meeting the general lending guidelines, specific lender requirements called mortgage overlays may have disqualified you from getting the home loan you want.

For the lender to reconsider your application and possibly approve you for a loan, you may need to jump over a few hurdles. Read on to learn more about mortgage overlays and how to take care of them when buying a home.

What Is a Mortgage Overlay?

Federal guidelines specify criteria borrowers must meet to qualify for home loans, but lenders are free to go a step further by implementing tougher guidelines known as mortgage overlays to decrease the likelihood that borrowers will default on their home loan.

These additional rules can be applied to Fannie Mae and Freddie Mac conventional loans as well as government-backed mortgage loans, including FHA, USDA and VA loans.

Mortgage overlays are sometimes prompted by unstable market conditions that increase risk to the lender. They can also result from red flags in your financial profile, the property type or the loan type you're considering.

Generally, you will know if you are subject to mortgage overlays when applying for a home loan. Here are examples of mortgage overlays that could affect you:

  • Debt-to-income ratio (DTI): Conventional loans typically have a maximum back-end DTI (the sum of all your monthly debt payments divided by your monthly gross income) of 43%, but some lenders require a lower DTI than that.
  • Credit history: Lenders want reassurance that you can responsibly manage your debts, and thus sometimes require a minimum number of credit accounts and years of experience to qualify for a mortgage.
  • Employment history: Applicants with minimal or shaky employment histories may not qualify for a home loan even if they meet other requirements.
  • Credit score: Federal guidelines state you can qualify for an FHA loan with a 580 credit score and 3.5% down payment (or score as low as 500 with a down payment of 10%). Still, many lenders that issue FHA loans only consider applicants with credit scores of 620 or higher. Conventional loans are available with credit scores of 620, but some lenders set the minimum score at 640 or higher. USDA loans don't have a federally required minimum credit score, but most lenders require a score of at least 640.
  • Property type: Some lenders restrict the types of property eligible for a mortgage.
  • Bankruptcy: Consumers with discharged bankruptcies can qualify for home loans per federal guidelines. However, most lenders have overlays that require a waiting period of one or two years.
  • Down payments: Select conventional mortgages require a down payment of 3%, but lenders don't always follow suit. In fact, some won't approve the loan unless you bring 5% or even 10% to the table. Some lenders restrict or disallow the use of gift funds, which is money you put toward a down payment that was given to you as a gift.
  • Cash reserves: Federal mortgage guidelines generally require a few months of reserves to qualify for a home loan, but some lenders won't approve borrowers with less than six months' worth of mortgage payments stashed away.
  • Collections and charge-offs: FHA guidelines do not require collections and charge-offs to be paid in full to qualify for a home loan, but some lenders have overlays that prevent applicants with unsettled or unpaid delinquent accounts from qualifying.

Can You Avoid Mortgage Overlays?

You can potentially avoid overlays by shopping around with different lenders. Some lenders don't have overlays that would disqualify you from borrowing, or your financial profile may be strong enough to avoid them with other lenders.

If you find a lender you like, they may be willing to remove certain overlays in exchange for a higher interest rate or larger down payment.

Still no luck? Consider returning to the drawing board to improve your credit and overall financial health before trying again at a later date.

How to Prepare Your Credit for a Mortgage

The first step in getting your credit ready for a mortgage is to check your credit, so you know where you stand. You can get a copy of your credit report for free from all three bureaus—Experian, TransUnion and Equifax—from AnnualCreditReport.com. You can also get your Experian credit report and FICO® Score for free from Experian.

Review your credit reports and note areas that need improvement. If you spot information you believe to be incorrect or outdated, promptly contact the appropriate creditor or file a dispute with the credit bureaus.

Here are some other suggestions to prepare your credit for a mortgage:

  • Pay all your bills on time. Payment history accounts for 35% of your FICO® Score, so just one missed payment could mean bad news for your credit score. Lenders could also see you as a riskier borrower and charge you a higher interest rate as a result.
  • Get current on past-due debts. Delinquent accounts can ding your credit score each month you don't bring them current. If possible, pay off collection accounts and charge-offs as it could be tougher to get a mortgage if these accounts remain unpaid.
  • Lower your credit card balances to reduce your credit utilization rate. Approximately 30% of your FICO® Score is determined by the amounts you owe on your accounts, and how your revolving account balances compare with your credit limits (your credit utilization) is the primary factor. The lower your credit utilization, the better, but aim to at least keep your credit usage below 30%, as this is the point where its effect on your credit becomes more severe.
  • Don't apply for new credit. Each new application creates a hard inquiry, which could temporarily lower your score by a few points. One or two credit inquiries almost certainly won't be enough to significantly alter your creditworthiness, but they could make a difference if your score is right on the edge of a scoring range.

If you've recently been denied a mortgage, reach out to the lender to learn why your application wasn't approved. The loan officer may be able to provide insights to help you resolve any issues causing overlays to be applied to your file.