Mortgage Overlays Explained
What’s an Overlay? An Overlay is a mortgage industry term that highlights an additional qualifying requirement(s) beyond what the guidelines issued by Fannie Mae and Freddie Mac. FHA, VA and USDA loans can also have overlays. These guidelines are set forth for several reasons, but one is to provide lenders with mortgage program stability as well as allowing lenders to sell loans, either individually or ‘in bulk.
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.
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. 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 up the ante a bit and set the minimum score at 700.
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.
If a lender asks for a 680 score your loan officer will 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.
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.
Finally, lenders can’t dilute loan program requirements. In other words, lenders can’t apply an overlay to lessen the requirements. Reducing approval requirements means the loan won’t have the minimum features that secondary markets require. If a lender does in fact reduce the requirements the loan can still be made, it’s just that the lender can expect to keep the loan in its own possession for the life of the loan.
One important concept you should familiarize yourself with is the “lender overlay,” which is essentially an expanded guideline (or set of guidelines) on top of what Fannie Mae, Freddie Mac, or the FHA/VA will allow.
Think of it as a second coat of paint, applied after the primer. The primer is the bare minimum necessary, but you don’t see people driving around too often without that second coat.
The same goes for mortgages. Fannie Mae, Freddie Mac, and the FHA/VA all set underwriting guidelines for residential mortgages, but they don’t actually lend directly to consumers.
Their job is to purchase and/or securitize the home loans that fit their guidelines, which is why they exist to begin with. Essentially, to keep the mortgage market liquid.
By doing so, lenders are able to sell their loans more easily, knowing they fit certain pre-determined criteria, which allows them to originate more loans via that increased liquidity.
Written by David Reed for www.RealtyTimes.com Copyright © 2022 Realty Times All Rights Reserved. Reed is from Austin, Texas and is the author of The Real Estate Investor’s Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. A Senior Loan Officer and Mortgage Executive for more than 20 years, he has also appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show.
