Overlays Explained
What are Overlays? An Overlay is a mortgage industry term. In simple terms, overlays are additional qualifying requirements on top of the guidelines set by Fannie Mae and Freddie Mac, as well as FHA, VA and USDA. These guidelines are set forth for several reasons but one is to provide lenders with mortgage program stability. This allows lenders to sell loans, either individually or ‘in bulk.’ Selling mortgages in the ‘secondary’ market allows lenders to continue making mortgage loans.
Understanding the Secondary Mortgage Market
Think about that for a moment. If there were no secondary market at some point the mortgage company would run out of money to lend. When a lender makes a loan it draws down some money from its credit line and replenishes that credit line once the loan(s) is sold. This process occurs over and over again. Very few lenders make a long term mortgage loan by keeping it in-house, or in its ‘portfolio.’
Lenders deal in risk every day but at the same time they want to minimize that risk as much as possible and still have a loan eligible for sale in the secondary markets. Minimizing risk can mean adding qualifying guidelines on a specific loan program. These are overlays. The loan meets the minimum guidelines for secondary sale but additional overlays can reduce the risk of making the loan. Overlays can also be used to target a specific type or class of borrower. To reduce risk, a lender might ask for a greater down payment than is originally required.
Overlays and Credit Scores
Let’s look at credit scores as an example. While Fannie might ask for a minimum credit score to be 680 a lender might decide to set the minimum score at 700. Note, both Fannie and Freddie can adjust minimum score requirements based upon the loan amount compared to the value of the property. This ‘loan to value’ can rise and fall based upon the amount of down payment. In the case of a refinance, it’s based on the amount of equity in the property. In this example, the higher score requirement of 700 meets the conventional guideline but provides more security for the lender. Some lenders might decide to cater to the higher income borrower with higher credit scores so they impose different overlays to reach their objective.
Catering to different groups means catering to a particular market or class of borrower. One lender may continue to stand firm with a 680 score while another decides 700 is better. Many borrowers may not know about this dynamic. This can mean applying for a mortgage at a mortgage company, getting declined and thinking that all lenders are the same and stop their search for a new home. All they really needed to do was to continue shopping for a lender who would approve the very same loan, just without the harsher overlays.
Benefits of Working With a Mortgage Broker
The prevalence of overlays also highlights the benefits of working with a mortgage broker. Part of my job is to keep up on different loan guidelines and lenders. Keeping up with these changes comes from my own research as well as working with various mortgage lender representatives who routinely contact my office to let me know of new loan programs and changes. If a lender asks for a 680 score I’ll know where to send a loan with a sub-700 FICO. These overlays can be placed on both conventional as well as government-backed mortgages. The government-backed mortgages are those underwritten to FHA, VA and USDA program guidelines.
What’s Next
Overlays can come and go over time. A lender might set forth a new overlay and then a year later remove it or even enhance it. It’s completely up to the individual lender as long as the loan is approved using established guidelines. What lenders can’t do is weaken guidelines. There are no overlays to drop the minimum score requirement from 680 to 650, for example. Doing so would mean the mortgage didn’t meet program guidelines and the loan could no longer be sold. Overlays help protect the lender while at the same time providing borrowers with additional choices.
