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What Are Mortgage Overlays?

Buying a home can be a pretty intimidating process. Just when you feel you have a handle on things, you learn about another document to provide or financial measures to meet. If you're shopping for a home in today's economy, getting a mortgage maybe even more involved than usual. The lender you've been working with may have introduced new mortgage overlays, which means you have to keep up with a new set of requirements.

So, What Are Mortgage Overlays?

To understand mortgage overlays, it helps to have a foundation of how the mortgage approval process works. Mortgage lenders always have underwriting guidelines—standards to determine the amount and terms you qualify for.

Minimum guidelines are typically set based on the mortgage program, e.g., FHA, VA, or USDA. FHA, for example, allows homebuyers to qualify with a minimum 580 credit score, a 3.5% down payment, and a debt-to-income ratio lower than 43%. A conventional mortgage, whose requirements are set by Freddie Mac and Fannie Mae, may require a minimum credit score of 620 and a 5% down payment with a debt-to-income ratio below 36%.

Sometimes lenders put additional requirements—a mortgage overlay—on top of existing program guidelines to lower the default risk of new mortgages issued. These overlays allow lenders to set their own guidelines that make sense for their business.

In uncertain economic times, mortgage lenders may respond to the uncertainty with more caution, tightening mortgage requirements to responsibly and sustainably offer mortgage loans.

Why Borrower Risk Is Important

Mortgage lenders typically sell mortgages to investors on the secondary market, using the proceeds to generate money so that they can issue new mortgages to more borrowers. Because it's difficult for lenders to sell riskier mortgages, they create additional guidelines to ensure they're only issuing mortgages that would make attractive investments—both lenders and investors want the mortgage loans to do well over time and make for a sound investment.

What this means is that when economic conditions change, lenders may adopt mortgage overlays that adjust the down payment requirement, the FICO Score requirement, or the debt-to-income ratio requirement for a mortgage.

What Can Homebuyers Do?

Buying a home is still possible even with mortgage overlays. Be prepared for increased scrutiny over your finances as lenders comb through your finances to identify potential risk factors. This applies even if you're considering a refinance.

Remember that you have the option of waiting out the economic uncertainty and look for a mortgage once overlays relax. Waiting may also give you time to improve your financial picture and save a bigger down payment, with the potential to qualify for even better terms. Your FICO Score isn't set in stone and can change over time, so give yourself the opportunity to practice financial self-care to reach your goals.

Shop Around and Take Advantage of the FICO "dedupe"

As always, make sure you're shopping around with different lenders to get the best rates. Different mortgage lenders may have different requirements, even for the same type of loan. Remember that as long as you keep your loan shopping within a short timeframe, your FICO® Scores won't be impacted.

For FICO Scores calculated from older versions of the scoring formula, this shopping period is any 14-day span. For FICO Scores calculated from the newest versions of the scoring formula, this shopping period is any 45-day span. The FICO Score treats multiple inquiries in these time periods as just one inquiry, which is why it's called a "dedupe."

LaToya Irby

LaToya Irby is a financial writer with over 14 years of experience. She's been quoted and published as a credit expert in several major publications including USA Today, U.S. News and World Report, TheBalance.com, and The Chicago Tribune.