3.3 Underwriting Guidelines
Key Takeaways
The Ability-to-Repay (ATR) rule requires lenders to verify eight factors including income, assets, debts, credit history, and DTI before making a loan
Qualified Mortgages (QM) provide legal safe harbor and must have points/fees <= 3% for loans >= $100,000, no negative amortization, term <= 30 years, and fully amortizing payments
Front-end DTI (housing ratio) compares housing expenses to gross income with a traditional benchmark of 28%, while back-end DTI includes all debts with benchmark of 36%
GSE QM loans allow DTI up to 45% (or 50% with strong compensating factors) while General QM uses a 43% DTI limit
Automated underwriting systems (DU and LPA) evaluate loan applications in seconds and provide conditional approvals with required documentation lists
Manual underwriting requires human review for loans that don't pass automated systems and applies stricter compensating factor requirements
Mortgage underwriting determines whether a borrower qualifies for a loan. Understanding the Ability-to-Repay (ATR) rule and Qualified Mortgage (QM) standards is essential for MLO exam success.
Ability-to-Repay (ATR) Rule
The Ability-to-Repay rule requires lenders to make a reasonable, good-faith determination that a borrower can repay their mortgage. This rule was created by the Consumer Financial Protection Bureau (CFPB) under the Dodd-Frank Act.
Eight ATR Factors
Lenders must consider and verify at least eight factors:
| # | Factor | What Lender Verifies |
|---|---|---|
| 1 | Current income or assets | Pay stubs, tax returns, bank statements |
| 2 | Current employment status | Verification of employment (VOE) |
| 3 | Monthly mortgage payment | Calculate P&I, taxes, insurance, HOA |
| 4 | Monthly payments on other loans | Credit report |
| 5 | Monthly payment for mortgage-related obligations | Property taxes, insurance, HOA |
| 6 | Current debt obligations | Credit report, alimony, child support |
| 7 | DTI ratio or residual income | Calculate housing + all debts vs. income |
| 8 | Credit history | Credit report, scores |
ATR Applies To
- All residential mortgage loans
- Primary residence, second homes, investment properties
- Purchase, refinance, and home equity loans
ATR Exemptions
Some loans are exempt from ATR requirements:
- Reverse mortgages (HECMs)
- Temporary or bridge loans (12 months or less)
- Construction phase loans
- Timeshare loans
- Certain community development loans
Qualified Mortgages (QM)
A Qualified Mortgage is a category of loans that meet specific requirements and provide legal protection to lenders. QM loans are presumed to comply with ATR requirements.
QM Requirements
| Requirement | Standard |
|---|---|
| Points and Fees | <= 3% of loan amount (for loans >= $100,000) |
| Loan Term | 30 years or less |
| Negative Amortization | Not permitted |
| Interest-Only | Not permitted |
| Balloon Payments | Not permitted (with limited exceptions) |
| Fully Amortizing | Required - must pay principal over loan term |
| Verification | Income/assets must be verified |
Points and Fees Thresholds
| Loan Amount | Maximum Points/Fees |
|---|---|
| >= $100,000 | 3% |
| $60,000 - $99,999 | $3,000 |
| $20,000 - $59,999 | 5% |
| $12,500 - $19,999 | $1,000 |
| < $12,500 | 8% |
Types of Qualified Mortgages
| QM Type | DTI Limit | Description |
|---|---|---|
| GSE/Agency QM | Up to 50% | Loans eligible for Fannie/Freddie/FHA/VA/USDA |
| General QM | 43% | Loans meeting General QM standards |
| Seasoned QM | None (performance-based) | Loans held 36 months with no 60+ day delinquencies |
Safe Harbor vs. Rebuttable Presumption
| Category | Rate Threshold | Legal Protection |
|---|---|---|
| Safe Harbor QM | APR <= APOR + 1.5% | Strong presumption of compliance |
| Rebuttable Presumption QM | APR > APOR + 1.5% | Compliance can be challenged |
APOR = Average Prime Offer Rate (published weekly by CFPB)
Debt-to-Income (DTI) Ratios
DTI ratios measure a borrower's monthly debt obligations compared to their gross monthly income.
Two Types of DTI
| Ratio | Also Called | Formula |
|---|---|---|
| Front-End DTI | Housing ratio | Housing expenses / Gross income |
| Back-End DTI | Total DTI | All monthly debts / Gross income |
Front-End (Housing) DTI
Includes:
- Principal and interest (P&I)
- Property taxes (T)
- Homeowner's insurance (I)
- HOA fees (if applicable)
- Mortgage insurance (if applicable)
Traditional Benchmark: 28%
Back-End (Total) DTI
Includes everything in front-end PLUS:
- Minimum credit card payments
- Auto loan payments
- Student loan payments
- Personal loans
- Child support/alimony
- Other monthly obligations
Traditional Benchmark: 36%
DTI Limits by Program
| Loan Program | Maximum DTI |
|---|---|
| Conventional (with AUS approval) | 45-50% |
| FHA | 43% (up to 50% with compensating factors) |
| VA | No maximum (residual income required) |
| General QM | 43% |
| GSE/Agency QM | Based on AUS approval |
DTI Calculation Example
Borrower's Monthly Finances:
- Gross monthly income: $8,000
- Proposed mortgage payment (PITI): $1,800
- Car payment: $450
- Student loans: $350
- Credit cards (minimum): $200
Calculations:
- Front-End DTI: $1,800 / $8,000 = 22.5%
- Back-End DTI: ($1,800 + $450 + $350 + $200) / $8,000 = $2,800 / $8,000 = 35%
Automated Underwriting Systems (AUS)
Most loans are evaluated using automated underwriting systems before manual review.
Major AUS Platforms
| System | Owner | Used For |
|---|---|---|
| Desktop Underwriter (DU) | Fannie Mae | Conventional, FHA |
| Loan Product Advisor (LPA) | Freddie Mac | Conventional |
| GUS | USDA | USDA loans |
| VA LAPP | VA | VA loans |
How AUS Works
- Data Entry: Loan officer inputs application data
- Analysis: System evaluates credit, income, assets, collateral
- Finding: System issues approval or referral
- Conditions: System generates required documentation list
AUS Findings
| Finding | Meaning |
|---|---|
| Approve/Eligible | Loan meets guidelines, likely to close |
| Approve/Ineligible | May qualify with different product |
| Refer with Caution | Requires manual underwriting |
| Out of Scope | Cannot be evaluated by AUS |
Benefits of AUS
- Speed: Decisions in seconds vs. hours/days
- Consistency: Same criteria applied uniformly
- Documentation: Clear list of required items
- Risk Assessment: Statistical analysis of default probability
Manual Underwriting
Manual underwriting occurs when a loan cannot be approved through AUS or lender policy requires human review.
When Manual Underwriting Required
- AUS returns "Refer" finding
- No credit score available
- Loan doesn't fit AUS parameters
- Lender overlay requires it
Manual Underwriting Requirements
Manual underwriting typically requires:
- Lower DTI limits (36-45% vs. 50%)
- More reserves (2-6 months PITI)
- Stronger compensating factors
- Additional documentation
- More stringent credit review
Compensating Factors
Compensating factors are positive characteristics that offset weaknesses in an application.
Common Compensating Factors
| Factor | How It Helps |
|---|---|
| Large down payment | Reduces LTV, demonstrates financial capacity |
| Cash reserves | Proves ability to handle emergencies |
| Minimal DTI increase | Payment similar to current housing |
| Strong credit history | Demonstrates payment reliability |
| Stable employment | Long tenure, consistent income |
| Residual income | Money left after paying all expenses |
| Cash-out reduction | Refinancing to lower rate/payment |
Using Compensating Factors
| Weakness | Potential Compensating Factor |
|---|---|
| High DTI | Large reserves, strong credit |
| Lower credit score | Large down payment, low DTI |
| Limited credit history | Large reserves, stable employment |
| Self-employment | Two+ years same business, strong reserves |
Documentation Types
| Documentation Level | Description |
|---|---|
| Full Documentation | Tax returns, pay stubs, W-2s, bank statements |
| Reduced Documentation | Fewer documents, typically for strong files |
| Bank Statement | 12-24 months of bank statements for self-employed |
| Asset Depletion | Qualifies on assets rather than income |
Non-QM Documentation
Non-QM loans may use alternative documentation:
- Bank statements (12-24 months)
- 1099 income only
- Asset-based qualification
- DSCR (debt service coverage ratio) for investors
Key Takeaways
- The ATR rule requires verification of eight borrower factors
- Qualified Mortgages must be fully amortizing with term <= 30 years
- QM points/fees cannot exceed 3% for loans $100,000+
- Front-end DTI = housing expenses only; back-end DTI = all debts
- Traditional DTI benchmarks are 28%/36% but QM allows higher
- AUS provides fast, consistent loan decisions
- Compensating factors can offset application weaknesses
Under the ATR rule, which of the following is NOT one of the eight factors lenders must consider and verify?
Current income or assets
Property appraisal value
Monthly mortgage payment
Credit history
For a $400,000 Qualified Mortgage, what is the maximum amount of points and fees the lender can charge?
$8,000 (2%)
$12,000 (3%)
$16,000 (4%)
$20,000 (5%)
A borrower has gross monthly income of $10,000, a proposed mortgage payment (PITI) of $2,500, a car payment of $500, and student loans of $300. What is their back-end DTI ratio?
25%
30%
33%
38%
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