Underwriting & credit
Compensating Factors: Definition & Example
What Is Compensating Factors?
Compensating factors are strengths in an application, such as large savings, long job history, or low payment shock, that can offset a weakness like a high debt-to-income ratio or thin credit.
What does compensating factors mean?
Underwriting guidelines allow exceptions when other parts of an application are strong. FHA and VA guidelines, for example, list specific compensating factors that can justify higher ratios in manual underwriting.
Common compensating factors include significant cash reserves, minimal increase in housing payment, a long and stable employment history, residual income well above the minimum, a strong rent payment history, and additional income not counted in qualifying.
Landlords use the same idea informally. An applicant slightly below the income requirement may be approved under the written criteria with a guarantor, a larger deposit, or proof of substantial savings.
Compensating factors example
An FHA borrower’s DTI is 47%, above the standard manual limit. The underwriter documents two compensating factors: six months of reserves and a new housing payment only $50 higher than the rent he has paid on time for three years. The loan is approved.
Related terms
- Manual UnderwritingManual underwriting is when a human underwriter evaluates a loan application directly, rather than relying on an automated underwriting system, usually for borrowers with limited or unusual credit.
- Cash ReservesCash reserves are liquid funds a borrower or business still has available after a transaction closes, often measured in months of housing payments or operating expenses.
- Debt-to-Income RatioDebt-to-income ratio (DTI) is the percentage of a person’s gross monthly income that goes toward monthly debt payments, including housing, car loans, student loans, and minimum credit card payments.
- Residual IncomeResidual income is the money left over each month after paying major obligations such as housing, debt payments, taxes, and basic living costs. The term also refers to passive income that keeps arriving after the initial work.
- GuarantorA guarantor is a person who signs an agreement promising to pay a tenant’s or borrower’s obligations, such as rent, if the tenant or borrower does not pay.
