In this delicate era of the post-housing meltdown, would-be borrowers are encountering tougher rules and guidelines as they try to qualify for a loan. (Keith Srakocic/Associated Press)

If the word “overlay” has you thinking about tablecloths or a thin veneer of gold over fine china, it’s clear you haven’t spent much time around mortgage lenders.

The word “overlay” in the context of home loans refers to the mortgage approval standards that lenders and their investors place above the guidelines set by Fannie Mae, Freddie Mac, the Federal Housing Administration and the Department of Veterans Affairs.

While many real estate professionals bemoan the tightened lending standards put in place since the housing crisis, restrictive lending practices are not solely the responsibility of the federal government. Instead, a combination of the government’s standards and investors’ desire to avoid the debacle of a flood of foreclosures has made it harder for would-be borrowers to qualify for a mortgage.

“Any lending institution can put additional overlays above the government’s guidelines to ensure that they get the types of the loans they want and to mitigate risk,” says Doug Benner, a senior loan officer with 1st Portfolio Lending in Rockville. “Some lenders, like 1st Portfolio, sell our loans directly to Fannie Mae and Freddie Mac, so we don’t add any overlays at all.”

While a few lenders keep their mortgages on their own books and don’t sell them on the secondary market, most lenders sell their loans to investors. In that case, the investors are the ones who impose overlays above the government guidelines in order to avoid the risk of the lender being forced to buy back a bad loan, be sued by borrowers or to experience a high level of loan defaults.

“Overlays work a lot like car insurance,” says Gregg Busch, vice president of First Savings Mortgage in McLean. “If you have two accidents on your record, then you’re going to pay a higher car insurance premium because you’re a higher risk. Same thing with a home loan; if you have a low credit score, have a lot of debt and are making a low down payment, you’re a higher-risk customer.”

A specific list of overlays typically comes directly from investors rather than from the lender, says Thomas Caouette, branch manager of Envoy Mortgage in Ellicott City, Md.

“Everyone uses risk-based pricing these days, so anytime a loan is considered to be a little more risky the borrowers should expect to pay more for their loan,” Busch says. “There are two ways to do this; either by paying points or extra fees upfront at the closing or by paying a slightly higher interest rate. Most borrowers choose to pay a higher interest rate rather than come up with cash at the closing, particularly because we live in a high-priced housing market.”

Some overlays can require borrowers to pay one point, equal to 1 percent of the loan amount to be paid at settlement, or $4,000 on a $400,000 loan in addition to other down payment and closing costs.

Fannie Mae and Freddie Mac themselves require lenders to charge an extra fee or higher interest rate when borrowers do not meet certain guidelines, Busch says.

“For example, borrowers who have a FICO score of less than 740 must pay a slightly higher interest rate than the advertised interest rate,” he says. “Borrowers with a score between 720 and 740 will pay about one-half a point as a fee or about one-eighth of 1 percent higher interest rate. For every 20 points difference in FICO score, borrowers will pay about another one-eighth of 1 percent higher rate.”

Other examples of higher fees or rates required by Fannie Mae and Freddie Mac include a 3 percent fee or three-eighths of a percent higher rate for borrowers who make a down payment of less than 20 percent, and three-fourths of one point or a one-eighth percent higher rate for condo buyers who make a down payment of less than 25 percent, Busch says.

“These add-ons can be layered on top of each other, so if you’re making a low down payment and have a lower credit score, you can end up paying several points or an interest rate of 1 percent or more above advertised rates,” Busch says.

Once these add-ons are combined with overlays, borrowers may find they cannot qualify for a mortgage at all or that the monthly payments are too high.

Why and how lenders use overlays

Most lenders change their overlays over time, says Michael Reddington, a regional vice president for the Northeast region for Envoy Mortgage in Boston.

“When loan applications are down, sometimes lenders will loosen their guidelines to generate more business,” Reddington says. “On the other hand, sometimes they’ll add more overlays if they’re seeing a trend toward more delinquencies or are lending in a market where home values are going down. For instance, they may add an overlay and choose not to make loans for a loan-to-value of more than 75 percent if values are declining.”

Reddington says the ultimate goal of most lenders is to make sure their loans can be sold to investors. If their loan conditions for borrowers don’t match up with investors’ conditions, then the loan cannot be sold.

Overlays are used to reduce lenders’ and investors’ exposure to defaults and foreclosures.

“FHA guidelines say they’ll insure loans for borrowers with credit scores in the low 500s and they don’t set any particular minimum credit score,” Benner says. “But most lenders won’t approve an FHA loan with a credit score of less than 620 or 640 to avoid the risk of a default.”

Benner says the most common overlays focus on credit scores.

“Private mortgage insurance companies also have overlays that are usually a little stricter than lender overlays,” Benner says. “If your credit score is 700, it will cost you more in interest on your loan; and if you make a down payment of less than 20 percent and have to pay private mortgage insurance, your premiums will be higher than someone with a credit score of 740.”

Benner says even if borrowers have just one risk factor such as a low credit score, they should expect to pay a higher interest rate. For instance, if two borrowers are identical in every way except for their credit score and each makes a down payment of 20 percent, the borrower with a credit score of 780 might pay 4.5 percent interest while the borrower with a credit score of 670 might pay 4.625 percent.

“Some investors add overlays about the number of credit lines a borrower has, such as requiring two to three lines of credit with five or more years of use,” Reddington says. “Job stability is another common lender requirement, with investors wanting to see a two-year history instead of just six months.”

Borrowers with a debt-to-income ratio of 43 percent or higher may be simply blocked from getting a loan, says Caouette, but those with a relatively high ratio combined with a low credit score should expect to pay more for their loan.

Consumer options to avoid overlays

“The best thing consumers can do is not to look for something to buy that they can’t afford,” Caouette says. “The lending industry is trying to find a happy medium in terms of loan approval standards and wants to help customers make the right choices to get into a house they can truly afford.”

Reddington says that a good loan officer can educate borrowers and help them develop a plan to improve their credit and get to a point where they can qualify for a loan.

“Consumers should find out their credit score well before they plan to buy a home,” Benner says. “If your score is under 740, then try to get your score higher to mitigate overlays.”

Busch says increasing the size of your down payment can also reduce the number of overlays imposed.

“When you make a bigger down payment, it means you have more teeth in the deal and you’re less likely to walk away,” he says. “This is all about reducing risk for the lender.”

Reducing your debt and increasing your assets are also ways to compensate for a lower credit score or a low down payment and improve your chances of a loan approval and a lower interest rate.

In spite of the persistence of lender overlays, Caouette says borrowers should recognize that it’s not impossible to get a mortgage.

“The numbers have to work and you have to document everything, but it’s not as hard as you think to get a mortgage,” he says.

Benner says overlays are an important reason for consumers to shop around for a loan with multiple lenders.

“Not all companies have the same overlays, so just because one company turns you down for a loan or charges you a higher rate, another may not,” Benner says. “Every borrower is unique, so if you contact multiple lenders you may be able to get a lower price for your loan.”

Lerner is a freelance writer.

Eight reasons your mortgage could have an ‘overlay:’

The word “overlay” in the context of home loans refers to the mortgage approval standards that lenders and their investors place above the guidelines set by Fannie Mae, Freddie Mac, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA). The additional approval requirements can add to the cost of your mortgage.

Your mortgage could cost more in terms of higher upfront fees or a higher interest rate if your lender and the investors who buy loans from your lender feel that your loan is even slightly risky. Here are some of the reasons your loan could be more expensive than the lowest possible interest rate:

●Your credit score is lower than 740. Lenders typically look at three credit scores (from Experian, TransUnion and Equifax) and pick the middle score to use for your loan qualification.

●You’re making a down payment of less than 20 percent — or refinancing with less than 20 percent in home equity.

●You’re purchasing or refinancing a condo. Condos are considered a riskier investment because their value is dependent on the financial health of the association and other owners in addition to the individual buyer.

●If you have a limited credit history, such only one or two lines of credit or a credit profile shorter than five years, a lender may view you as a higher risk than someone with a 10-year credit profile.

●Your debt-to-income ratio is a little high, and you have another factor such as a lower-than-optimal credit score.

●Your job history is limited. Some lenders want to see at least two years in the same job, while others are satisfied with six months in a position as long as other elements of your application are strong.

●You have limited cash reserves. Even lenders that don’t have specific requirements for cash reserves prefer evidence that borrowers will be able to continue making loan payments even if they are briefly unemployed or have unexpected financial obligations.

●Home values in your area are declining or lack stability. Your loan is dependent on the collateral — your home — as well as your creditworthiness, so if there’s uncertainty about future values the lender may opt to charge a little extra for your loan or ask for a bigger down payment.

Online chat

Mortgage rates have plummeted to 14-month lows. New mortgage approval standards are making it much tougher to qualify for a home loan. Craig Strent, CEO of Rockville-based Apex Home Loans, will be online taking your home finance-related questions. Submit them early and join us Tuesday, Oct. 21, at 1 p.m.