www.hudclips.org U. S. Department of Housing and Urban Development Washington, D.C. 20410-8000 January 27, 1995 OFFICE OF THE ASSISTANT SECRETARY FOR HOUSING-FEDERAL HOUSING COMMISSIONER MORTGAGEE LETTER 95-7 TO: ALL APPROVED MORTGAGEES SUBJECT:Single Family Loan Production - Revised Underwriting Guidelines and Other Policy Issues Last year, we established an Underwriting Working Group (Group) comprised of representatives from State and local housing finance agencies, community-based organizations, trade associations, government-sponsored enterprises, mortgage lenders, consumer groups, and other interested parties. The purpose of the Group was to review FHA's underwriting guidelines and recommend changes and modifications that would: (1)Eliminate unnecessary barriers to homeownership, (2)Provide the flexibility to underwrite creditworthy non-traditional and underserved borrowers, and (3)Clarify certain underwriting requirements so that they are not applied in a discriminatory manner. The Group has met and worked since last summer. The revisions to the FHA guidelines described below result from the recommendations made by the Group. These revised guidelines represent significant underwriting changes that will enhance the homebuying opportunities for a substantial number of American families and are effective immediately. In addition, the work of the Group has been so productive that it will continue to meet periodically as FHA embarks upon the development of future programs and further refines its underwriting guidelines. 2 I.ELIMINATION OF FIVE-YEAR TEST FOR INCOME STABILITY. Up to now, only those sources of income reasonably expected to last five years could be included in determining the borrower's income for qualifying purposes. However, we are revising our policy to require that the income be expected to continue for the first three years of the mortgage for it to be used in qualifying the borrower. We believe that this is a more reasonable, yet prudent, income requirement. Consequently, all references in HUD Handbook 4155.1 REV-4 that require income to last for the first five years of the mortgage, to be considered as effective income, are hereby revised to read the first three years of the mortgage loan. A revised mortgage credit handbook incorporating these and other changes is scheduled to be issued this year. II.RECOGNIZING INCOME FROM OVERTIME AND BONUSES. We are modifying our guidelines to address those circumstances where a borrower may not have been receiving overtime or bonus income for a full two years or for those that work for employers unwilling to indicate the continuance of such income. Now, overtime and/or bonus income received less than two years is acceptable where the lender determines that there are reasonable prospects of its continuance. As always, an earnings trend over that period of time of receipt must be established and analyzed. The underwriter must adequately document the file and justify his or her reasons for using the income for qualifying purposes. Only if the employment verification specifically states that bonus or overtime is not likely to continue may that income not be considered in the qualifying ratios. III.RECOGNITION OF PART-TIME INCOME. Some lenders have been interpreting the requirements for including part-time income in the ratios as also applying to borrowers who work less than 40 hours per week. However, our definition of part-time income refers to jobs taken in addition to the normal, regular employment to supplement the borrower's income, i.e., a second job and should not be construed as meaning jobs of less than 40 hours per week. If a borrower's regular employment is simply less than a typical 40 hour work week, the stability of that income should be evaluated as any other regular, on-going primary employment. This would include, as an example, a registered nurse that has been working 24 hours per week for the last year. This is the borrower's primary job, even though less than 40 hours, and should be included as effective income. There may also be acceptable situations where income from a part-time job, as described above, has been received for less than two years but may be included as effective income. The lender must determine that the continuance of this income is reliable and provide a strong explanation for including such income as effective income in qualifying the borrower. 3 IV.DEFINITION OF LONG TERM OBLIGATIONS EXTENDED TO TEN MONTHS. We are now requiring only those debts extending ten or more months be included in the debt-to-income ratios. Underwriters must, however, consider the borrowers' total obligations and their ability to meet these obligations during the months immediately following loan closing. V.ELIMINATION OF CHILD CARE AS RECURRING DEBT. Although we realize that child care can be a major expense for many families, we are no longer requiring that child care be considered in the computation of the debt-to-income ratios. We believe that most families, in assessing their financial priorities, will find alternate means of caring for their young children if such costs become burdensome. Court-ordered or voluntary child support payments must continue to be counted as recurring debts. VI.USING CASH SAVED AT HOME AS FUNDS TO CLOSE. Borrowers who have saved cash at home and are able to adequately demonstrate the ability to do so are permitted to have this money included as an acceptable source of funds to close the mortgage. However, to include such funds in assessing the homebuyer's cash assets for closing, the money must be verified, whether deposited in a financial institution or held by the escrow/title company and the borrower must provide evidence of the ability to accumulate such savings. The asset verification process requires the borrower to explain how such funds were accumulated and the amount of time taken to do so. The lender must determine the reasonableness of the accumulation of the funds based on the borrower's income stream, the time period the funds were saved, spending habits, and history of using financial institutions. VII.CASH ACCUMULATED WITH PRIVATE SAVINGS CLUBS. The Department is aware that there are certain ethnic groups that use non-traditional methods of saving money by making deposits into private savings club. Often, these private savings clubs pool resources for use among the membership. If a homebuyer claims that the cash to close a FHA-insured mortgage is from savings held with a private savings club, the borrower must be able to adequately document the accumulation of those assets with the club. While we acknowledge such clubs are not supervised banking institutions, nevertheless there must exist, at minimum, account ledgers, receipts from the club, a verification from the club treasurer, as well as identification of the club that would permit the lender to re-verify the information provided. The underwriter must be able to make a determination that it was reasonable for the borrower to have saved the money claimed and that there is no evidence these funds were borrowed with an expectation of repayment. 4 VIII.FLEXIBILITY IN QUALIFYING RATIOS AND COMPENSATING FACTORS. From discussions with the industry, it is apparent that many lenders and some local HUD offices have often been of the belief that HUD's housing expense and payment-to-income ratios were inflexible. However, as evidenced by the discussion of compensating factors in our guidelines, it has always been HUD's intent to allow ratios to be exceeded where significant compensating factors exist. We also do not set an arbitrary percent by which ratios may never be exceeded nor may any local HUD office. Rather, we rely on the underwriter to judge the overall merits of the loan application and to determine what compensating factors, if any, apply and the extent to which ratios may be exceeded. Underwriting remains more art than science and requires that the underwriter carefully weigh the many aspects of the mortgage. While we specifically recognize several compensating factors as described in the mortgage credit analysis handbook, we also are aware that each loan is a separate and unique transaction and that there may be other factors that demonstrate the borrowers' ability and willingness to make timely mortgage payments. Underwriters must state on the mortgage credit analysis worksheet the compensating factors used to support loan approval. IX.ACCEPTANCE OF REVISED CREDIT REPORT REQUIREMENTS. Until now, HUD has always required a Residential Mortgage Credit Report (RMCR) for each borrower. However, our policy is now being revised to permit, under most circumstances, a "three repository merged credit report" (TRMCR) rather than a RMCR. Lenders, of course, may choose to only use RMCRs if that is the lender's credit policy. The credit report, whether a TRMCR or a RMCR, must contain all credit that is available in the repositories, be accurate and complete and provide an account of the credit, residence history, and public record information of each borrower responsible for the mortgage debt. The basic credit report standards described in paragraph 3-3B of HUD Handbook 4155.1 REV-4 apply to TRMCRs as well as RMCRs. The credit report submitted to HUD must be the original received electronically and printed by the lender's printer or delivered by the credit reporting agency. There must be no whiteouts, erasures or alterations. The report must indicate the name and address of the consumer reporting agency and each account listed must show the primary repository from which the particular information was pulled. The name of the party ordering the report must also be shown. While the TRMCR should prove sufficient for processing most loan applications, the circumstances that require ordering of a RMCR include: 5 1.The borrower(s) disputes accounts on the TRMCR as not his/hers/theirs; or 2.The borrower(s) claims that collections, judgments, or liens reflected as open on the TRMCR have been paid and cannot provide separate documentation supporting this; or 3.The borrower claims that certain debts shown on the TRMCR have different balances and/or payments and cannot provide current statements (less than 30 days old) attesting to this fact; or 4.The lender's underwriter determines that it would be prudent to utilize a RMCR in lieu of a three repository merged report to properly underwrite the loan. If the lender orders a TRMCR and subsequently orders a full RMCR, the borrower may only be charged for the RMCR. A borrower may not be charged for both a TRMCR and a RMCR on the same loan except when delays on the part of the borrower require the TRMCR to be updated and a RMCR is ordered for one of the reasons described above. Most credit reporting agencies will not charge for the TRMCR if the RMCR is ordered within 13 days of the TRMCR. The lender must make every effort to determine the need for the RMCR within this timeframe to avoid the additional charge. As always, the borrower may only be charged in the amount billed by the credit reporting agency. X.UNNECESSARY REPAIR REQUIREMENTS on FHA APPRAISALS. The Department is sensitive to the perception that appraisers may require unnecessary and cosmetic repair requirements on FHA appraisals. While under no circumstances may the safety and soundness of the property be compromised, HUD acknowledges that some repair requirements could and should be eliminated. DE underwriters should exercise their authority to delete conditions that have little or nothing to do with the safety and soundness of the property. Local offices, lenders, and appraisers are not to impose requirements that are neither necessary nor are reflective of the typical housing market in a given area. XI.AUTOMATED UNDERWRITING SYSTEMS and USE OF ARTIFICIAL INTELLIGENCE IN UNDERWRITING. HUD recognizes that some lenders are beginning to use automated underwriting systems and artificial intelligence to approve mortgages. While HUD will not approve individual automated underwriting systems, we will allow lenders wishing to use them as a means of approving FHA-insured mortgages. The automated system may have been developed by the lender or by a vendor. Lenders desiring to participate in this limited program must describe the type of 6 system being used (e.g., rules-based programs, judgment-based programs), how long the system has operated, and the criteria that must be met for loan approval. The artificial intelligence system may be used for loan approvals only; loans rejected by an artificial intelligence system must be reviewed by a human underwriter. The request to adopt artificial intelligence may come from HUD-approved lenders only. Although we anticipate regulatory modifications to permit recognition of the lender's artificial intelligence program as an approved underwriter, until then an approved DE underwriter must still execute the normal documents required on FHA-insured mortgages. All requests should be directed to Richard Manuel, Acting Director, Single Family Development Division, Room 9272, US Department of HUD, 451 7th St., SW, Washington, DC 20410. XII.ALTERNATE QUALIFYING METHODS for HOUSING FINANCE AGENCIES. HUD has had a long and successful history of providing the credit enhancement of FHA mortgage insurance through the affordable housing programs of State and local housing finance agencies. These housing finance agencies are permitted to adopt additional methodologies in qualifying borrowers for FHA-insured mortgages beyond the application of income ratios. We have been advised that many have done so. Among the attributes that are generally considered in qualifying a homebuyer using an alternate qualifying method are the housing expenses he or she has been paying, the savings the homebuyer has accumulated, tax benefits of the mortgage interest deduction, non-housing debt history, and the amount of income remaining after all obligations for the month. We also recognize that some borrowers meeting ratio tests may still not have sufficient income to pay the mortgage and other recurring obligations, and have enough cash flow remaining to support the family's other needs. Since it is also our intent to explore and approve alternate methods of qualifying potential borrowers, including cash-flow analysis and other methods, we invite State and local housing finance agencies with affordable housing programs to submit their homebuyer approval methodologies, including their analysis worksheets, housing counseling requirements, etc., to us. Upon approval of a particular underwriting methodology, we will notify the housing agency of its acceptance for FHA mortgage insurance. We will also maintain information on these various approval methodologies that we can share with other State and local housing finance agencies. The approval requests should be directed to Richard Manuel, Acting Director, Single Family Development Division, Room 9272, US Department of HUD, 451 7th St., SW, Washington, DC 20410. 7 XIII.DE APPROVAL FOR BRANCH OFFICES. As part of the Department's continuing efforts to reduce unnecessary paperwork and delays in obtaining Direct Endorsement approvals, once a lender obtains unconditional DE status for any one of its offices, additional branch offices that become approved to do business with HUD will automatically also be granted DE approval. This means that separate requests for DE need not be submitted to the local HUD office when the lender is requesting branch office approval. DE test cases, etc., are also not required for new branch offices once the lender obtains unconditional approval. XIV.ALTERNATE DOCUMENTATION---REVISED INSTRUCTIONS. In describing HUD's requirements for alternate documentation on verification of employment, the mortgage credit handbook 4155.1 REV-4, paragraph 3-1F described telephone verification requirements that the lender must follow, including verifying all employment for the past two years. However, in recognizing that there will be situations where the former employer is no longer in business and that emphasis must be made on employment the borrower has at the time of underwriting, these instructions are revised to read that the lender must verify by telephone all current employment. Also, since bank statements indicate the previous month's ending balance as well as all transactions during the current month, the requirement that the lender obtain statements covering the most recent three month period may be met by obtaining the most recent two original bank statements. With regard to using forms such as IRS 4506 or 8821 for obtaining tax returns under the alternate documentation program or for self-employed or commissioned individuals, the lender may use an electronic retrieval service for W-2 and tax return information. However, the lender may not pass on any additional charges to the borrower for this service. XV.UNDERWRITER APPROVALS---APPRAISAL EXPERIENCE. In HUD Handbook 4004.1 REV-1, CHG-2, paragraph 2-4A(3), the Department listed coursework that would constitute one full year's worth of full-time experience reviewing appraisals. The course listing is revised to read "Seminar on Appraisal Techniques," sponsored by the Mortgage Bankers Association of America (MBA). Additional information may be obtained by calling the Education Department of the MBA at (202) 861-6578. XVI.MORTGAGE CREDIT CERTIFICATES (MCCs). Direct Endorsement Lenders may now consider the tax credit resulting from MCCs as a direct reduction in housing expense. Although the tax credit results in an increase in the borrowers net monthly income, lenders may now use the credit as deduction from the monthly PITI payment. This will reduce the borrowers' qualifying ratios and increase the size of mortgages available to them. 8 Lenders using the tax credit as a direct reduction in housing expense must develop and use a worksheet that estimates the amount of the mortgage credit available, determines the adjusted monthly PITI payment, and confirms that borrowers generate sufficient tax liability to use the available credit. Loan files must contain copies of the mortgage credit certificate and the worksheet. If you have any questions regarding the issues discussed in this Mortgagee Letter, please contact your local HUD Office. Sincerely, Nicolas P. Retsinas Assistant Secretary for Housing- Federal Housing Commissioner