CHAPTER 4

Qualifying the New Way: Understanding Automated Underwriting Systems

UNDERWRITERS ARE individuals who are highly regarded in the mortgage business, and those underwriters who have been in the business for a long time have earned their way to the top and can make a very good income. Some underwriters even obtain a special status that authorizes them to underwrite certain types of loans that other underwriters aren’t qualified to fully approve.

There are several factors that a loan application must pass muster on before an approval is issued but they fall into two basic categories: property and borrowers. We will discuss these, before moving on to the details of the automated underwriting system.

PROPERTY

The property is one of the two main considerations when seeking a loan approval. Even if the borrower had perfect credit with 50 percent down and single-digit debt ratios, if the property didn’t pass muster with the lender, it wouldn’t matter how strong the borrower was.

Does the lender like one type of property and not like another type? Is it easier to get a loan for a three-bedroom brick home than it is for a two-bedroom condominium? Are duplexes more desirable because they can generate income through rentals?

Lenders don’t prefer one property type over another, but what they do like to see is that the property in question doesn’t stick out like a sore thumb in the neighborhood. In other words, are there similar properties nearby or down the street that have recently sold? Is the subject property a single-family residence? Is it a townhouse? Are there other single-family residences or townhouses? Such similar properties are called “comparable sales” or simply “comps.” Conventional as well as government loans require that there be other properties in the area that would be considered equivalent property types. This is, after all, the lenders’ collateral, and marketability of the property is essential.

New Changes to Appraisals Mean More Work, More Money

Specifically, such guidelines ask that there be at least three other properties in the area, ideally within one mile of the subject property, that have sold within the previous 12 months. Why is that important to a lender?

Recall that the secondary market, which buys and sells mortgage loans, likes loans that are similar in nature. That includes the property type. If there are three other similar properties that have sold within a one-mile radius, then the property would be considered “normal” or “standard” for the area.

Lenders need to view the property in such a light to prepare for a worst-case scenario; should the lender ever have to foreclose on the property due to nonpayment, would the lender have a property that is similar to other properties, or would it have on its hands a white elephant that would take forever to sell due to some unique set of characteristics?

For instance, the seller of a property had a penchant for geodesic domes, so he built one right smack in the middle of Normalsville, USA. He might be able to find a buyer who also has fallen in love with geodesic domes who has more than 20 percent down, great credit, and sufficient income to qualify for a mortgage.

If it’s the only geodesic dome in the neighborhood, there will be no mortgage loan. The property wouldn’t have any comps. No other geodesic domes, no mortgage. By contrast, if the property in question is a three-bedroom, two-bath brick home, it’s likely that other homes in the area are similar, with perhaps some two-bedroom and fourbedroom homes of similar size. Then the property would be acceptable to the lender.

It’s the appraiser who establishes for the lender the marketability of the property, both in terms of comps and sales price.

The availability of comps is a key element of marketability. But what if there are no comps within one mile of the subject? If that’s the case, then lenders will accept an explanation of the market that while there are comparable sales, there aren’t very many of them due to the size of the neighborhood or the town where the property is located. As long as the case is made that the property does, in fact, have comps, and even though the comps are outside the one-mile radius, then a lender would still consider the loan.

The other piece of the marketability puzzle is to justify the price of the home. Say there’s a three-bedroom home for sale at $300,000. The home has been on the market for a couple of months when finally an offer is accepted at $280,000. The lender engages an appraiser to appraise the property. As part of the appraiser’s research, the appraiser is provided a copy of the executed sales contract. It is in this way that the appraiser attempts to justify the sales price agreed to for the property. Sales contract in hand, the appraiser does some research by accessing the local multiple listing service, a database for real estate that is currently listed or recently sold, to see if there are other properties in the area that are within one mile of the subject and sold within the previous 12 months.

The appraiser will make note of the potential comps and visit each one, along with visiting the subject property. The appraisal itself is a narrative with pictures of both the subject property and the comps.

The appraiser will compare all the properties, using things such as square footage, number of bedrooms, number of bathrooms, the size of the lot, and so on. The appraiser will then review the sales prices of the comps and compare them to the subject.

Generally speaking, if a home sold for $300,000 and is 3,000 square feet, then the house sold for $100 per square foot. If the subject home is 2,800 square feet and sold for $280,000, then the subject home sold for $100 per square foot.

The appraiser will do the very same thing with the other comps to see if the price per square foot method seems to fit the other houses as well. If all the other recent comps sold for somewhere around $100 per square foot, then it’s likely the sales price of the subject property is within range of other local sales. If a property in the neighborhood sold for much less than that, say $80 per foot on a 2,800 square foot home, or $224,000, then there will be some more research needed to adjust for the lower price per square foot.

These “adjustments” vary, and there can be some subjectivity to them. For instance, one home might have a swimming pool that was installed for $25,000. That won’t necessarily add $25,000 to the value of a home. Some people don’t want a swimming pool in their backyard. Perhaps the kitchen has been significantly updated with granite countertops and top-of-the-line appliances. Updated kitchens can add value to almost any home.

Still more, one property might be sitting on a hilltop and have a nice view of the valley below from the living room, while the other comparable sales are down the hill with no view whatsoever. The value of the home at the top of the hill will be adjusted upward to account for the superior view the property enjoys compared to the other properties.

Once the appraiser has visited all the properties and accounted for their adjustments, the appraiser will determine whether the subject property supports the value listed in the sales contract.

Most often, that is the case. A “market value” means the amount on the sales contract that represents the highest price the buyer was willing to pay compared to the lowest price the seller was willing to accept, all things being equal.

All things being equal means the offer and acceptance were made without duress under the very same market conditions. For instance, the seller of the property had to sell quickly or be foreclosed on, thus lowering the price to attract a quick offer. In a stable market, the sales contract and the appraisal almost always agree.

Still another new change in appraisal guidelines is an addition to the appraisal report itself. This addition is called the market conditions report. In addition to finding previous sales, new changes require more stringent guidelines.

Without knowing about these guidelines in advance, you could find yourself making an offer on a home and the appraisal not coming in at the proper valuation. Say that you made an offer on a home for $300,000 and the appraisal report came back with a valuation of only $280,000. This presents a significant problem.

Lenders base loan amounts and down payment requirements on the lower of the sales price or appraised value. In this example, the loan would be based on $280,000 and not $300,000. If the lender requires 5 percent down on the loan, the 5 percent would be based on $280,000.

If the seller stands firm and demands the sales price hold at $300,000 then the buyer must make up the difference. Instead of coming into the closing with 5 percent of $300,000, or $15,000, the buyer must now come in with 5 percent of $280,000 plus $20,000, representing the difference between $300,000 and $280,000.

Declining Market Means More Down Payment

The new changes require the market conditions report, which describes the local real estate market in its current condition. This report will help to identify what is called a declining market. A declining market is a local real estate market where real estate values have been declining consistently over the previous 12-month period.

When an appraiser does the research and finds that home values have declined, the appraiser must complete the report as well as make an indication on the appraisal report itself identifying the local market as “declining.”

In a declining market, a lender will require another 5 percent down, regardless of the original loan approval. Again, using the same $300,000 sales price with 5 percent down, if the market is identified as declining, then the lender will require 10 percent down and not 5 percent. That’s another $15,000.

You should use your agent or someone such as an appraiser who can help with identifying current market values, because it could affect the ability to get your loan approved. Remember, it’s not just you and your credit that get approved, but the property as well.

In addition to finding at least three sales in the previous 12 months, the appraiser must also find a minimum of two comps that are within three months of the appraisal date. In addition, at least two active listings must be in the report. A listing is a home that is for sale on the market but hasn’t yet sold. This is a significant departure from previous appraisal requirements, because a listing may or may not sell for the advertised price. Often, the list price is open for negotiations between the seller and the buyer.

The appraiser must also use current sales and listing data to reflect what is called a list to sales price ratio. This ratio shows the difference between the original list price and what it finally sold for. The report must also research any changes in list prices while the home is being listed for sale.

For instance, the home could have originally been on the market for six months at $300,000 with no offers. Then the seller dropped the list price to, say, $290,000. The appraiser must report that price change.

Watch Out: Too Many Seller Concessions Can Lower Your Value

Finally, the appraiser will research the market to see if the current sales offered any seller concessions. On closed comparable sales, the appraiser can determine whether or not the seller of the property agreed to pay some closing costs on behalf of the buyer. For example, the buyer and seller could agree on a $300,000 sales price, but the seller agrees to pay $3,000 in buyer closing costs.

On a closed sale, that seller concession is reported on the appraisal form. The new requirements mean the appraiser must note any pending sales—sales that are in the process of closing but not yet closed—that have any sort of seller concessions in the contract. If it is determined that the seller gave up too much in the form of seller concessions, the lender just might deduct that amount from the appraised value. When seller concessions exceed 4 percent of the sales price, be prepared to see your value reduced. That means coming into the closing with more down payment money.

All of this requires extra work on behalf of the appraiser, and sometimes not all of this information is available. Perhaps the appraisal asks for two recent sales within 90 days of the appraisal date and there are none. In the instance where the lender requires information that simply isn’t available, the appraiser will be asked to address that fact in a written report.

These additional changes help the lending industry when evaluating appraised values when compared to contracts, but it also means appraisers now charge more for their services. These additional reporting requirements can add another $100 to a standard $350 appraisal.

Title Issues: It Has to Be Yours

Another important consideration regarding the property identifies any current legal interests in the property itself, any previous liens that haven’t been released, or any personal judgments against the owner of the property that may lay claim to the real estate.

A title report is a report that gives a historical record of any previous ownership in the property. If Joe originally owned the property and later sold it to Sally, who later sold it to Bob, who later sold it to Tim, then this “chain of title” would serve as a record of not just who owned it, but that ownership legally changed hands from one party to the next.

When Joe sold the property to Sally, the sale would be legally recorded as a public document where Joe gives up all interests in the property and transfers the real estate to Sally, usually as a result of selling the property. A title report will make certain that the property legally changed hands and Joe had no more legal claims to the property. The same would be recorded when Sally sold the property to Bob, and so on.

Sometimes property transfers don’t completely release the property into a buyer’s hands. A common instance might be that Joe was originally married and his ex-wife owned part of the real estate but didn’t relinquish her interest in the property to Sally. Or there might be a previous lien that was recorded on the property but never released. A roofing contractor may have done some roof work and filed a mechanic’s lien on the property while the work was being performed. Such liens are commonly filed during any work on real estate to ensure the contractor gets paid. Once the contractor gets paid for work performed, the contractor releases the lien.

Sometimes, the contractor and the property owner disagree—for instance, on whether or not the job was completed satisfactorily— and the homeowner refuses to pay. The lien remains on the property until at such the time property is sold or transferred to another party. If there is a previously recorded lien on Joe’s property that hasn’t been released, then the lien will have to be paid before Joe can sell the property to Sally, who will then be recorded as the legal owner.

Other issues with title can result in a lawsuit or damages awarded to someone if there is a judgment levied by the court on the owner of the property. If Sally got into a lawsuit and lost, then the winner of that suit might place a lien on her house until she paid the settlement.

If the title report comes in “clean” meaning there are no previous unsettled claims or illegal transfers of ownership, the lender will determine that the property is eligible to make a loan against it.

BORROWERS

We reviewed borrower characteristics in the previous two chapters with regards to credit, income, and assets, but underwriters now need to know more about all three other than what appears at face value.

You Must Have Established Credit

We discussed how credit is established and the items that make up a credit report in Chapter 2, and we’ll discuss how to repair credit in Chapter 8.

Big Changes: All Income Must Be Verified

One big change is that all income must be verified. At first glance, this might sound obvious, but for years, when an automated underwriting system would evaluate a loan application, sometimes it wouldn’t require the lender to verify that you make what you said you made on your loan application. Experienced loan officers could review a loan application and credit report and tell whether income documentation was required. In many instances, not even a pay stub would be needed, and there was only a phone call to the employer to see if the applicant was still employed. Not anymore. Income documentation is now a part of every single loan file.

Income is used to calculate debt ratios and each program can have its own maximum debt ratio. But exactly what type of income is available, and how is it calculated?

The first requirement is that the income must be derived from full-time employment. We’ll discuss how part-time income can be used later in this chapter. Full time typically means at minimum 36 hours of work each week for those who get paid hourly. They work for someone else and get paid on a regular basis.

This is the easiest type of income to verify, as the verification of the income is stated on the W-2 issued by the federal government and can be matched up using pay stubs. If the W-2 says the borrower makes $24,000 per year and the borrowers pay stub reflects $2,000 per month in gross income, then the income can then be verified. Verified means documented by a third party, in this case the employer and the federal government.

This verification method works for both salaried as well as hourly employees. For those paid by the hour, the underwriter reviews the W-2 as well as the most recent pay stubs covering 30 days.

The pay stub will reflect how many hours were worked during the pay period (remember, a minimum of 36 hours counts as full time), as well as the hourly pay rate. If the borrower made $12.00 per hour and worked 80 hours for a two-week period, the underwriter would figure out the borrower worked 40 hours per week at $12.00 per hour, or $480 per week. The underwriter would multiply $480 times 52 (weeks) to get $24,960, then divide that amount by 12 (months). The result is $2,080 gross income per month.

Debt ratios use gross monthly income, but what if someone gets paid every other week and not twice per month? Careful now—there is a difference. Each month doesn’t contain exactly four weeks. February does in a non–leap year, but that’s it.

To calculate the income for someone who gets paid every other week, take the gross pay for that pay period and multiply that by 26, the number of pay periods per year for those who get paid every other week. That’s 52 weeks divided by two.

If someone makes $4,000 every other week, then she would make $8,667 per month. That’s $4,000 times 26 weeks divided by 12.

What about that hourly employee who works overtime; how are those numbers calculated? In order for an underwriter to use overtime as regular income, the overtime must be proven to be consistent. Consistent means having a two-year history of overtime, as well as a letter from the employer stating overtime is likely to continue.

This is sometimes hard to satisfy. Employers can be reluctant to put anything in writing with regards to future overtime, but an underwriter can make the determination by reviewing pay stubs and previous years W-2 information.

Part-Time Changes: Same Line of Work and One Employer

Part-time income can also be a challenge. Part-time income must also show a two-year history of part-time work and, of course, still be employed in the part-time position. Even if there is a history of parttime employment, it must now be part-time employment in the same line of work. Further, many lenders won’t accept part-time income from separate employers, regardless of there being a two-year history.

Those are the easy income calculations. An underwriter will manually calculate gross monthly income from these sources. But what if you are self-employed?

Old Underwriting Requirement Returns to Haunt the Self-Employed

Without a doubt, the biggest change for those who are self-employed is how long they need to be self-employed in order to count their income. First and foremost, you must be self-employed for at least two years, as verified by income tax returns.

There were other ways lenders could use self-employment income, as long as income from the previous six months could be established, but that guideline went away and an old one returned; two years of tax returns.

Notice that doesn’t mean two years self-employment, it means two years of tax returns showing self-employment income. The distinction between the two works like this; say you started a business in October of 2008. Eighteen months later would be April 2010 and likely you’ve filed two years of tax returns, one for 2008 and one for 2009. You’ve just met the income requirements for the selfemployed by evidence of two years’ worth of returns. But you haven’t met the requirement to be self-employed for two years. For that, you’ll have to wait until October 2010

You’ll need to show at least some minimal income for your business for the year 2008, even if it was only a few hundred dollars. But once you’ve filed tax returns for 2008 and 2009 and business income is shown for tax years 2008 and 2009, you’re good to go. Once you’ve met both requirements, you can use your self-employed income.

Assets Can Be Liquid or Nonliquid

Assets are the third leg of the stool. In addition to having established credit and verifying income, underwriters will confirm the assets that are used for down payment when needed and for closing costs. Assets are funds brought to the closing table, most often in the form of a cashier’s check.

Assets can be money in the bank or in the stock market or in a retirement account. Liquid assets are funds you can access relatively quickly. Money in the bank or cashing in some stock is a liquid account. Money in retirement funds such as a 401(k) or IRA is considered nonliquid.

Lenders sometimes utilize an underwriting guideline called “reserves” in addition to funds needed for down payment and closing costs. Most often, lenders require these reserves for low-downpayment mortgages to bolster the overall file.

Reserves are typically defined in terms of months of house payments. If a lender requires six months’ worth of reserves and the house payment is $2,000 per month, then the loan approval will require $12,000 in additional assets beyond down payment and closing cost money. A nonliquid account would be used as part of the reserve asset, but not all of it. A lender can use 80 percent of the current value of the nonliquid account as reserves. This percent is used to estimate any early withdrawal penalties the borrower might incur should those reserve funds be accessed for any reason. Except if you’re a first time homebuyer.

	First-timers beware: There are changes in reserve requirements.

Lenders as well as mortgage insurance companies can require reserves, but if you’re a first-time homebuyer, neither will typically allow nonliquid funds to be counted as reserves. Especially with less than 20 percent down. If they are putting less than 20 percent down, first-timers take it on the chin two more times—once from the mortgage insurance company who won’t count reserves for first timers and second from the lien lenders, who may not count nonliquid assets, either. This is a little-known change that can have a huge impact on those buying their first home.

AUTOMATED UNDERWRITING SYSTEMS

An underwriter may manually review all aspects of the loan application, but this is unusual. For obvious reasons, this process is called manual underwriting. It’s performed by hand and can take hours. But manual underwriting has all but disappeared. It used to be an option, but nowadays, lenders don’t like to manually underwrite loans. Loans are now approved using an automated underwriting system, or AUS.

During a manual underwrite, the underwriter literally evaluates the entire file, doing what an automated system can do in mere seconds. When a human makes any number of calculations, as underwriters do when evaluating a loan request, the possibility for mistakes is increased. If a mistake is made on a loan file and the loan goes bad, the loan has to be bought back by the original lender as described in the first chapter.

Make Sure Your Loan Application Is Ready for Automated Underwriting

Automated underwriting systems came about during the late 1990s and were used primarily for conventional loans. Instead of a human underwriter making a loan decision, a loan application is converted electronically then submitted to the AUS. Within a few moments, the approval is issued, along with a list of conditions—much like an underwriter would review a loan manually, but in reverse.

Instead of manually approving a loan with a list of conditions to come after the underwrite, the file is submitted electronically to obtain the list of conditions. Only after the loan has been submitted to the AUS will the file begin to be documented. This is done to see if the loan itself is eligible for approval, and if it isn’t, then the loan will either be declined or the lender will determine whether the loan has enough merit to be approved with the skills of a human underwriter.

Lenders don’t like that sort of risk. If a loan doesn’t get approved with an AUS and the lender decides to go ahead and approve it anyway, the lender will either have to keep the loan or hope it can sell the loan on the secondary market.

If a loan doesn’t get an automated approval, then it’s much less likely the loan could be sold. And if the loan did get approved with a manual underwrite and the loan in fact was sold, if the loan ever went bad, the original lender would be required to buy the loan back from the entity it first sold it to. Lenders don’t like such a potential albatross and rely on an AUS as a quality control mechanism to ensure the loan meets secondary guidelines.

When loan officers take a loan application, they run the application to check for errors and then submit the application to an AUS. Each loan type has its own automated underwriting system. Fannie Mae has the Desktop Underwriter and Desktop Originator, Freddie Mac uses Loan Prospector, FHA has the Scorecard, and VA and USDA use GUS, or government underwriting system.

In reality, these are all nearly identical in practice, with a few tweaks to adhere more closely to whichever type loan is being applied for. A VA AUS will make allowances for zero money down; FHA requires a minimum 3.5 percent down, for instance.

Loan officers can submit the application even though there is no property picked out. This is important for buyers who want their approval in their hands before they go house hunting. For instance, the buyers’ debt ratios might be high or the credit is shaky. Having the loan submitted through an AUS before shopping can put those fears to rest.

The AUS can also be used in order to tweak the loan application to get an approval. A loan that gets an approval from an AUS may not have a debt ratio requirement. Say that a buyer has a debt ratio of 52, much higher than a typical 38 ratio, and is not sure if the buyer could get approved.

In the past, an underwriter who performed a manual underwrite would likely decline the mortgage application due to such high ratios. But as long as an approval is issued with an AUS, it doesn’t matter what the ratios are to still have a loan that’s eligible for sale on the secondary market.

An AUS is a time saver for both the borrower and the lender. Historically, a loan officer would ask for nearly everything under the sun when taking a loan application. This means asking for anything that might possibly come up during the loan approval process. A typical request would be:

• Two years tax returns
• Two years W-2s
• Two months most recent pay stubs
• Year to date profit and loss statement
• Three months of the most recent bank and investment statements
• Name and contact information for homeowners insurance
• Copy of divorce decree, if applicable
• Letters of explanation for derogatory credit
• Letters of explanation for gaps in employment

All of this would be asked for before an underwriter ever saw the loan. Just in case it was needed. The file would be further documented by ordering all the legal and title work, plus the appraisal. Then the borrowers would wait to see if their loan was approved or not approved. That could take a couple of weeks or more, taking up precious time.

The AUS turns all that upside down. The loan application is run through the AUS and the decision comes back with a list of only the things needed to make the loan eligible for sale on the secondary market. It complies with conventional or government guidelines. After the loan has gone through the AUS, the list of documentation would then read something like this:

• One most recent pay stub
• Verbal verification of employment
• One most recent bank statement
• Evidence of insurance coverage

Notice that the list is much smaller. It can be much smaller because the AUS only asks for the things required to close the loan; no more and no less. The AUS will automatically review credit scores, sufficient funds available for closing, and debt-to-income ratios. All within a matter of moments.

Automated Double-Check: Note the Changes in the Automated Process

Lenders discovered that even loans with automated approvals can require additional work. These new changes took place primarily in two areas: mortgage insurance for loans with less than 20 percent down and income verification.

As mortgage insurance companies found themselves with insurance settlements they had to pay on loans that got approved with automated underwriting, they decided to take matters into their own hands. We’ll discuss in more detail these mortgage insurance changes later in this chapter, but mortgage insurance companies quit insuring conventional loans with less than 5 percent down, effectively eliminating Fannie and Freddie’s 3 percent down-payment, first-time homebuyer programs called “Home Possible” and “My Community.”

The next big change in double-checking an automated underwriting decision regarded verifying income. An AUS would ask the lender to verify the pay by a pay stub and a W-2, for instance, but lenders now take it a step further by requesting directly from the IRS the borrowers’ tax returns and W-2s for the previous two years—even if it was not required by the AUS, and even if the borrowers provided those items directly to the lender.

Historically, all borrowers would sign the IRS form 4506 with each initial loan application. This form would allow lenders to pull previous years tax returns to compare the income reported to the IRS to what was reported on the application. But this was only done in rare cases during a routine loan audit or the loan went into foreclosure.

Now, however, this is a huge change—the borrowers sign the IRS form 4506-T at application. During the approval process, the lender takes this form and obtains the previous two years of tax returns, W-2s, 1099s, and any other schedules the borrower may have filed. This is done electronically and takes only a day or two. When the tax information is received, the lender manually compares the income with what the IRS reported to the lender with what the applicants reported to the lender.

With the proper software, applicants can provide fake tax returns and even fake W-2s, but if they do that now, the loan will never make it past the underwriting stage. The applicants have just committed loan fraud and the lender has proof. The loan will be denied.

Get to Yes with an AUS

The AUS approval, then, is not automatic. Sometimes the loan is not approved. If that is the case, then the lender would make the determination of whether to manually override the AUS decision and underwrite the loan themselves without an AUS decision (highly doubtful) or the loan officer needs to adjust certain things on the loan application itself. When an AUS declines a loan application, the reason(s) for the declination will be listed on the AUS report in order of importance.

Recall that the AUS won’t have a maximum debt ratio but looks at the entire application at once to reach a decision. Let’s say that the borrower had a debt ratio that was 55. That’s high, but because of the good credit, the loan officer decided to try for the approval anyway.

So the loan officer submits the file to the AUS and gets a decline. The reason might read something like this:

• Debt to income ratios high
• Minimal down payment used

These reasons for declination could then be addressed and run again. If the debt-to-income ratios are too high, then try putting more money down. That strategy would address both declination reasons—ratios too high and minimal amount down. The loan officer would then massage the loan application, and instead of putting 5 percent down, the loan officer would enter 10 percent down and resubmit the application to the AUS.

The AUS could return with an approval and the borrowers would go about documenting their file per the AUS request. But what if the borrower doesn’t have additional funds to put down?

If the file is resubmitted through an AUS, the file must be documented in the exact same fashion as the new approval was issued. In this example, the borrowers must find some more down payment money, either by saving it up or getting a gift from a family member. We’ll explore unique sources of down payment and closing cost funds in detail in Chapter 7.

Change the Terms

Another way to change a decline into an acceptance is to reduce the monthly payment by taking a lower rate or extending the loan term. If the ratio was at 55 with an interest rate of 6.00 percent, then try submitting the application to the AUS yet again with a rate of 5.75 percent, lowering the payment, which lowers the debt ratio.

Longer-term mortgages, say a 30-year loan compared to a 15-year loan, will have lower monthly payments. Most lenders allow for loans to be amortized, or stretched out, over 40 years. So if a 30-year loan gets declined due to ratios, ask the lender to try the submission with a 40-year term.

Perhaps there are some debts that can be paid off. An AUS will consider an installment loan paid off completely, as long as there are less than 10 months remaining on the account. This is most common with an automobile loan.

Change Your Ratios

Let’s look at the 55 debt ratio problem again. If the loan is declined due to ratios, examine your credit report to see if there are any installment accounts that you can pay down below 10 months remaining.

Say your car payment is $500 per month and there is a $6,000 balance. That’s 12 months left, and the AUS would count that as a debt. But your loan officer can resubmit the application showing nine months remaining to see if you can get your approval. If your choices are to reduce ratios but you don’t want to or can’t come up with more down payment money to do so, then try reducing your loan balances by paying them down—but not completely, if you don’t want to.

Instead of coming up with an additional $15,000, or 5 percent on a $300,000 home, simply pay your car loan down by $1,500 so you have less than 10 months remaining.

Such scenarios can be run over and over again to try and obtain an approval. Note that resubmitting doesn’t mean trying to falsify your income. If you’re declined due to high ratios, you can’t simply enter more income on your application if you don’t have it. Lying on an application is fraud. Remember that the lender will verify the income at some point so you’re wasting your time.

AUS Approval: What It Says Is What You Do

After you receive your AUS approval and have complied with the documentation request, the loan is then sent to the underwriter for approval. But instead of calculating debt ratios, evaluating credit and reviewing bank statements, the underwriter simply goes down the list of required items to make sure the documentation matches up with the AUS approval.

An AUS approval could say, “Minimum investment $18,780,” and the underwriter would simply look at the bank statement to see whether there was a $18,780 balance. If there wasn’t, the underwriter would ask to see more funds either deposited into the account or saved up.

Or the approval would read, “Verify income of $5,000 per month,” and the underwriter would look at the pay stub to see if the borrower makes $5,000 per month. There is no need to calculate debt ratios, as the AUS decision has already performed that task. The underwriter simply makes sure the income is there and can be used as qualifying income.

The AUS works the very same way for a refinance as for a purchase loan. But instead of a sales contract establishing the value of the home, the homeowner makes a determination of the approximate value of the real estate. During a refinance application, the homeowner would say something like, “I’m applying for a $300,000 loan and I think my house is worth $500,000,” and the loan officer would input that information for the AUS.

You’ll notice that I mentioned how your loan officer or lender can resubmit your application after tweaking the application. Or that your loan officer or lender would submit your loan application to an AUS immediately upon receiving your application.

I’ll put it another way. Your loan officer or lender is supposed to do it that way. There are loan officers who still document files the old-fashioned way who don’t submit your file to an AUS until your loan is fully documented. This is foolish and can waste time as well as money. If your loan isn’t approved by your contract date, then you could lose your earnest money deposit.

Ask your loan officer at the outset if your loan has been submitted to an AUS. If it has, make sure you get a list of the items the AUS is asking for. If the loan officer hasn’t submitted your loan to an AUS, then have him do it immediately.

Automated underwriting is a real time saver as well as a method for lenders to ensure that the loans they approve fully meet lending guidelines and they can rest at night knowing their loans are sound. If the AUS issues an approval, traditional underwriting guidelines can be bypassed. That is, unless there’s mortgage insurance involved.

PRIVATE MORTGAGE INSURANCE

Mortgage insurance has been around since the 1950s, but it’s not the kind of insurance you might imagine. Sometimes when people hear the term “mortgage insurance” they think of an insurance policy that pays the mortgage if the homeowner gets sick or can’t work. That’s not how mortgage insurance works. It’s an insurance policy all right, but it’s a policy in favor of the lender, less so for the borrower.

Mortgage insurance can be called private mortgage insurance, or PMI, or can be the government brand of insurance in the form of a funding fee for VA loans, guarantee fee for USDA loans and the mortgage insurance premium, or MIP, for FHA loans.

Government insurance policies are paid by the borrower when they go to the closing table, and all government loans require it (except FHA loans that are amortized over 15 years, which do not require MIP).

Conventional loans require mortgage insurance when the loan amount is above 80 percent of the sales price or appraised value. If the value was $100,000, then if the loan was above $80,000, mortgage insurance would be required. Why have mortgage insurance at all, and why does the borrower have to pay it if the loss payee is the lender?

Recall in the first chapter how banks wouldn’t make a home loan unless the buyer had 20, 30, or even 50 percent or more for down payment? If someone wanted to finance a home but the home was higher than FHA or VA limits allowed, then the buyer would have to come up with a significantly higher down payment.

Enter private mortgage insurance, or PMI.

PMI was first invented in 1957 by an insurance company named Mortgage Guaranty Insurance Corporation, or MGIC. The policy worked this way:

If the lender required 20 percent down and the buyer had only 5 percent, MGIC would issue an insurance policy that would pay the lender an amount that worked out to approximately the difference between 5 percent down and 20 percent down.

When lenders saw that they really couldn’t lose in that situation, they began to allow for low-down-payment loans, as little as 3 percent or even less. MGIC would also underwrite the loan at the same time the lender underwrote the loan.

MGIC would review credit and income and assets just like the lender would before issuing a mortgage insurance policy.

MGIC would approve the policy, then send that insurance policy to the lender, who would include it with the loan file.

Mortgage insurance policies can vary in price, depending on the amount down and other credit factors. A mortgage insurance policy will be more expensive for someone with 5 percent down than for someone with 10 percent down because there’s less risk for the insurance company.

The permutations are many, as various factors can impact the price of the insurance, including credit score, loan type, amortization period, the amount of down payment, and even the type of property being acquired, such as a duplex or a condominium.

As a general rule of thumb, however, simply multiplying the loan amount by 0.5 percent and then dividing by 12 (months) would give the monthly mortgage insurance premium.

It is figured like this: 0.5 percent of $300,000 would be $1,500, which, divided by 12, is $125. The mortgage insurance payment (MIP) would be $125 with 5 percent down. With 10 percent down, the MIP would drop to nearly half that, to $75 per month.

With a loan that required insurance, the lender would make two separate loan files, one for its own underwriter and one for the insurance company. The loan would, in essence, receive two different approvals.

Later, in the 1980s, mortgage insurance was an established business with proven risk models. So much so that mortgage insurance companies began to allow lenders to underwrite mortgage insurance policies in the same fashion as the lender approved the mortgage application. Instead of sending out a loan file to the insurance company, the lender would obtain “delegated” underwriting authority.

That simply meant the insurance company delegated the approval process for the insurance policy to the lender. If the lender approved the loan application, then the mortgage insurance policy was also automatically approved. This made the process more efficient and ultimately saved the borrower, the lender, and the insurance company money.

In the late 1990s and early 2000s, more and more loan types were introduced. Most of these subprime and alternative loans asked for less than 20 percent down, or at least didn’t require 20 percent down. Since they were conventional loans with less than 20 percent down, the loans required mortgage insurance, and mortgage insurance companies developed policies for these new loan types. Lenders would introduce a new type of mortgage and send it to a mortgage insurance company to see if they would issue a mortgage insurance policy based on the new loan parameters. If the mortgage insurance company issued such a policy, then the lender was free to market the loan with little to nothing down.

Of course we all know what eventually happened. These loans began to default in large numbers, and that meant that mortgage insurance companies had to pay billions of dollars to mortgage companies in the form of an insurance payout.

Mortgage insurance companies then stopped the practice of allowing lenders to issue mortgage insurance policies if the loan itself was approved. Mortgage insurance firms across the board began to establish their own set of underwriting guidelines that had to be met in addition to any conditions the lender might issue.

This soon meant that a loan could get a loan approval but couldn’t get mortgage insurance approval. If a lender can’t get mortgage insurance on a loan with less than 20 percent down, the lender won’t issue the loan regardless of what the AUS said. Since PMI is “private” mortgage insurance, it only applies to conventional mortgages and not government-backed loans such as VA, FHA, or USDA.

You can now get an AUS decision but still not get approved because you couldn’t obtain PMI, because PMI now has underwriting guidelines of their very own. You’d have to wait to save up some more money to avoid down payment or elect to take out a second mortgage. We’ll discuss second mortgages in Chapter 6.

PMI’s new approval guidelines now require minimum credit scores, greater down payment requirements, restriction on property types, and debt-to-income ratio requirements.

PMI Now Has Minimum Credit Score Requirements

Perhaps one of the biggest changes in PMI is the requirement of minimum credit scores. As with mortgage loans, PMI did not used to require a minimum credit score as long as the loan was approved.

Now, however, PMI not only has a requirement for a credit score but it is more onerous than what lenders use. Lenders will ask for a credit score to be at least 620, but PMI companies demand that the score be 700 or better.

This 700 score is for purchases or refinance loans where no money is being taken out during the refinance, most often called a “rate and term” refinance. Still further, if the credit score is less than 720 but still 700 or above, the PMI policy will require at least two months of principal, interest, taxes, and insurance (PITI) in the bank for cash reserves.

This means that if the PITI (including mortgage insurance) is $3,000, then the PMI policy will ask that $6,000 in liquid reserves be verified. Liquid reserves are cash accounts that are available after the closing takes place.

If the borrower has to put 10 percent down on a $300,000 sales price plus $5,000 in closing costs, that would mean a total outlay of $35,000. But with the two months PITI reserve requirement with a $3,000 per month PITI payment, that would require verification of not only the $35,000 for down payment and closing costs, but also $6,000 for the cash reserve fund. Cash reserves aren’t given to the lender or PMI company but must be verified to exist.

There Are No More Zero-Down PMI Policies

Gone are zero-down conventional loans, and so are the PMI policies that covered them. There are 3 percent down loans from conventional lenders, but PMI policies don’t cover anything with less than 5 percent down. Even if the lender has a 3 percent down loan, PMI companies may not insure the mortgage, so it makes the 3 percent down loan essentially worthless.

PMI Now Only Covers Certain Property Types

PMI policies can now only apply to a primary residence, as PMI for investment (rental) properties are no longer available.

Condominiums are also restricted to purchase mortgage loans and can’t be used for a refinance loan. This impacts someone who bought a condo with 10 percent down and then two years later wanted to refinance because rates went down. Unless the value of the condo has appreciated enough that the loan no longer needs PMI, then the loan won’t close.

And also forget the notion that even if the condominium owner could, in fact, use PMI for a refinance, if the refinance pulled out cash, then that’s forbidden. As are PMI policies for duplexes, triplexes, and fourplexes.

PMI Now Limits Debt Ratios

Debt ratios are limited to 41 percent. This ratio includes all housing, revolving, and installment debt. Unlike conventional or government loans, where ratios are a general guideline as long as the loan receives an automated approval, the debt ratio requirement is typically nonnegotiable.

Finally, and perhaps the most striking changes with mortgage insurance, is the fact that some PMI companies no longer accept applications from third-party originators and that mortgage insurance is now tax deductible for first-time homebuyers.

PMI May Not Accept Loan Applications from Third-Party Originators

Third-party originators, or TPOs, are companies that originate a mortgage loan that are not lenders. This means mortgage brokers. We’ll examine the differences between mortgage brokers and bankers in detail in Chapter 5.

PMI Is Now Tax Deductible (for Some Buyers)

Prior to 2008, mortgage insurance was not tax deductible but an added expense to a monthly mortgage payment for the privilege of not having to put 20 percent or more down to buy a house.

This feature made mortgage insurance less attractive when compared to certain other options, such as a second mortgage being placed behind a first mortgage to avoid PMI. As PMI became tax deductible, it was on an even playing field with second mortgages, because monthly payments between PMI and second loans were essentially the same and also a tax deduction.

But not for everyone. This tax deductibility feature only applies to first-time homebuyers. A first-time homebuyer is specifically defined as someone who has not owned a home in the previous threeyear period. A lender can verify that fact by reviewing a credit report to see if a mortgage appeared on the credit report within the previous three years or even review personal income tax returns to see if a mortgage interest deduction was taken.

This does bring up a slight loophole in the guideline, because someone could have owned a house four years ago, sold it, and didn’t own a home for the previous three years. In this sense, someone who wasn’t actually a first-time buyer could, by definition, be one and qualify for tax deductibility of PMI.

SUMMARY

• Automated underwriting replaced manual underwriting methods.
• New appraisal requirements make them more thorough and more expensive to the consumer.
• Declining market indication requires buyers to put 5 percent more into the deal.
• Limits on seller concessions are in place.
• Properties must have clean history of ownership, evidenced by a title report.
• Everything in a loan application must be verified via third party.
• New rules apply to overtime and part-time income.
• Extinct underwriting rule requiring two years of tax returns for self-employed were reintroduced.
• Asset reserve requirements changed to limit the use of nonliquid accounts.
• New restrictions were placed on first-time homebuyers by lenders and mortgage insurance companies.
• Manual underwriting is mostly nonexistent.
• IRS 4506-T form is now required on all mortgage applications.
• AUS decisions can be tweaked to obtain an approval.
• Mortgage insurance companies developed their own underwriting guidelines.