You’ve heard me talk before about the importance of the secondary market as it relates to the mortgage industry. Understanding how underwriting works and why there are exceptions is just as important when it comes to your mortgage.
Mortgage Industry Overview
There is both a primary and a secondary market in real estate finance. The primary market is also referred to as “retail” as it refers to consumers getting a home loan to finance a purchase. The secondary market is concerned with the individual lender. The secondary market is where loans are bought and sold to one another. Who sells loans? Lenders do, pretty much all of them.
Without having the ability to sell a mortgage at some point the mortgage lender would no longer be a lender because the institution ran out of cash to lend. Instead, lenders apply for and receive a credit line from a bank. Each time a loan is approved and funded the lender draws on the credit line.
Here is where the secondary market comes into play. The lender is able to sell that loan and the proceeds from the sale replenish the line of credit. Most of the loans are purchased by mortgage giants Fannie Mae and Freddie Mac. As long as the approved loan meets guidelines the loan is eligible for sale. But there’s the key. As long as the approved loan meets these guidelines.
Strict vs. Flexible Guidelines
Lenders however do have a bit of leeway when evaluating a loan application. There are some strict guidelines and some that are not so much. For example, a strict guideline would be keeping the loan amount at or below the conventional conforming loan limit. If not, the loan is not eligible for sale and essentially stays on the lender’s books.
Where leeway comes into play is when there is no strict guideline but a guideline, nonetheless. The guideline provides guidance and gives the underwriter, the person who ultimately approves the loan, can make an underwriting exception to these listed guidelines. Example? The most common refers to how much money someone can borrow with a new mortgage and what those payments can be.
Conventional conforming loans have these limits and they’re referred to as debt ratios and there are two of them, a “front” ratio which compares the mortgage payment, including taxes and insurance, to qualifying monthly income. The “back” ratio adds the mortgage payment and other revolving and installment debt. A common set of ratios would be referred to as 33/41 for example. This means the mortgage payment should be at or around 33 percent of income. But here’s where an underwriting exception can be made.
An applicant gets a preapproval for a specific amount and the monthly payments pretty much fall in line. Now let’s say the applicant absolutely falls in love with a property that appears to be a little out of reach. Instead of a 33 front ratio, it works out to closer to 39. Both because of the higher sales price as well as mortgage rates have inched up a bit. The underwriter would then review the file to see if it would qualify for an exception. The representative credit scores are relatively high, with the qualifying score north of 740. This is considered in the “excellent” range and gives the underwriter confidence the loan is still eligible for sale due to the compensating factor of excellent credit.
Why are underwriting exceptions needed? There would be fewer houses sold and fewer mortgages made. With a strict debt ratio guideline, the applicant with a 39 ratio would be declined. The underwriter does take some risk here but knowing where the loan is going to be sold tells the underwriter if an exception can be made. However, if an underwriter does make the exception, the applicants should have no need to be concerned about the secondary market. If the loan is approved and funded, that’s pretty much the end of it and the lender moves onto the next loan in the pipeline.