Low doc loans are the new form of subprime loans that we all got so used to in the past. Because subprime really is not a thing anymore, lenders had to come up with a more creative program that still met the Ability to Repay Rules. This program is the low doc program, which essentially means you provide different documentation to prove your income rather than your paystubs and W-2s. In order for a lender to be willing to accept things like your bank statements or award letters as proof of your income, you have to have certain compensating factors.
What are Compensating Factors?
Compensating factors are things that make your loan less risky. Because you are not able to provide standard paystubs and W-2s, you are automatically considered risky. You might or might not actually be a high risk, but the lender has to assume this is the case. In order to make up for that risk, the lender must ask you to prove your worthiness, which is where compensating factors come into play. These factors can span a variety of categories – basically what you are doing is showing the reasons that you are not a high risk to a lender.
Large Down Payment
The most effective compensating factor is a large down payment. For example, consider the risk level between the following two types of borrowers:
- Borrower A borrows 90% of the purchase price of a house. On a sale price of $200,000, he puts down $20,000. Yes, that is a significant amount of money, but when compared to the $180,000 the lender invests, the value of the $20,000 is minimized.
- Borrower B borrowers 70% of the purchase price of the same house. So on $200,000, he puts down $60,000 and the lender puts out $140,000.
Even though the lender is putting out a large amount of money in both cases, Borrower B has more invested in the home, which means he will likely do more to make sure that he keeps the house. Yes, $20,000 is nothing to sneeze at and most people would not want to lose that investment, but when faced with losing $20,000 or trying to figure out a way to make ends meet, many borrowers let their home foreclose. With $60,000 invested already and the value of any payments the borrower makes, it would be much more important to do whatever is necessary to keep the home.
High Credit Score
Your credit score speaks volumes to lenders. At first glance, a lender knows right away what type of borrower you are, just by looking at your credit score. For example, a person with a credit score of 580 will be looked upon as a risk; he obviously has credit issues in his past and could potentially default on his mortgage. On the other hand, a borrower with a 700 or higher credit score likely does not have any late payments reporting on his credit history and poses a much smaller risk to the lender, even with a low doc loan.
Your employment history also says a lot about you. A person that bounces from job to job can look very risky. What proof does the lender have that you will not change jobs again or just walk out on your current job and remain unemployed? This is a huge risk for any lender, especially those offering low doc loans. In order to minimize this risk, you can show a lender a stable employment history, which in the eyes of the lender is any length of time longer than 2 years. Of course, the longer you are at one job, the more stable you will look to a lender.
Reserves are always a compensating factor for any type of loan. When you can prove that you have liquid assets that could be used for your loan payments should you run into financial trouble, you give the lender a guarantee that you will not default in the near future. Reserves of at least three to six months usually have the largest impact on a lender. Your reserves should include the amount of the principal, interest, taxes, and insurance in order to cover all aspects of the housing payment.
Compensating factors have a way of reassuring a lender of your ability to stay current on your loan. If you need a low doc loan because you are self-employed or work on commission, it helps to work on your compensating factors right away before you apply for a loan to make sure everything is in order so that a lender will want to approve you for the loan.