Let’s Talk Overlays

An overlay is a lender imposed, expanded guideline that is essentially “on top” of the real guidelines given by Fannie, Freddie, FHA or VA. Unfortunately, many loans today are denied due to “overlays” and aren’t really denied loans. Realtors and buyers take the denial at face value and just quit the process. I’m here to tell you to question everything. Every condition, every question, and most certainly, every denial. It may not be the truth.

The latest HMDA statistic show that about 12% of all purchase contracts had issues with financing and fell through. My assumption is that many of these things are due to lender overlays, and therefore, aren’t real.

There are 3 main types of lender overlays. Credit Overlays (i.e. FICO score), Debt-to-Income Overlays, and the biggie, Performance-Based Overlays.

Credit Overlays

The Credit ones are easy to spot. If a lender is denying a loan for credit score, either the loan officer didn’t do their proper due diligence or he got stuck with a lender overlay. Sometimes you’ll get a pre-approval from a lender because DU (the automated underwriting system) is run typically without the overlay. The loan officer issued the approval and went on his happy way until he found out his company has a massive reserve or other requirement due to the lower credit score. This is all too common with FHA and VA loans.

Debt-to-Income Overlays

These are a bit more tricky and easier to miss. Typically, these come in to play alongside a lower credit score or maybe a certain product type. For example, the lender may allow for an FHA credit score of 620, but requires the debt to income ratio be at 38 or better. I’m sometimes curious as to why some overlays exist as they are so strict; very few borrowers even qualify. If your borrower has a “debt to income” issue with a lender, definitely question it. I’ve heard of a recent case where because of a lender overlay, the underwriter was told to not count rental income which blew the deal up. And yes, the agency would allow the income to be used.

Performance-Based Overlays

This is probably the widest category of overlays. Lenders make a strategic decisions to do or not do loans based on historical performance of loans they originated. I know of a company that just doesn’t like to finance condos. They feel they are a higher risk and have evidence that for them, loans on condos didn’t perform as well as on single family homes. I used to work for a company that had an “FHA Compare Ratio” issue. They were in trouble by FHA with a higher than acceptable percentage of their FHA loans defaulting. So what did they do? They created an “overlay” to ensure quality. They raised the minimum credit score, lowered the maximum debt-to-income ratio, and even instituted a “no exception” policy for certain loans. All in order to get their loan quality up. Lenders can do what they want in this regard. They don’t have to follow the guidelines of the agencies. In this case, buyers who were denied for FHA financing were completely hosed as FHA denials follow the borrower from lender to lender and trying to get another FHA loan after a recent denial is challenging.

Who Has Overlays?

Any lender that sells their loans and doesn’t service the product being applied for will have overlays. The loan officer may tell you that they don’t have overlays, but they do. If a lender doesn’t service their loans, they are selling loan-by-loan to the end investor–Wells, Chase, BB&T, etc. and must adhere to their guidelines and overlays.

How Do you Get Away from Overlays?

Only lenders that go direct to the agencies can truly choose to not have any overlays. Companies like Caliber Home Loans or others that both originate and service their loans. You’d think that a big bank would be the safest stop. Well, absolutely not. They have many more eyes on their loan quality and shareholders to impress. After the financial crisis. it’s a tall order to get a bank to be flexible with your client’s loan.

Bottom line, question everything. Every condition that doesn’t seem right, every question, delay and every denial. You may be up against a lender overlay.

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