You were not declined by the rules. You were declined by an overlay.

A borrower came in last month with a decline letter from a national bank. Mid-FICO of 611, FHA purchase, 3.5% down, a clean rental history and a two-year job. On the published FHA guideline that file is approvable, because the program floor for 3.5% down is 580. The bank said no anyway.

What happened is the single most useful thing a borrower can understand about mortgage lending. The bank has an overlay: an internal rule stricter than the program itself. Their FHA floor is 620 regardless of what the Department of Housing and Urban Development permits. The borrower was not outside the rules. They were outside that one lender's version of the rules.

What an overlay actually is

Every loan program has a rulebook. Fannie Mae and Freddie Mac publish theirs, FHA publishes the handbook, the VA publishes its own. Those are the floors. Any lender is free to be stricter, and almost every lender is, because they carry the risk of a loan going bad in the first few payments and being asked to buy it back.

Overlays usually appear in five places:

• A higher credit score floor than the program requires
• A lower maximum debt-to-income ratio than the automated engine approved
• Extra reserve requirements, often two to six months of payments
• A refusal to underwrite manually, so anything the engine cannot approve is finished
• Property restrictions, such as declining condo projects with high investor concentration

None of this is misconduct. It is risk management, and a lender is entitled to decide what risk it wants. The problem is that a borrower standing in one branch has no way to see that the rule that stopped them is not a rule at all, it is a preference.

Why brokers exist because of this

We keep 24 wholesale lender relationships. That is not a marketing number, it is a working tool, because six of those lenders exist on our panel for one narrow purpose each. One takes FHA down to 580 with documented compensating factors. Two will use a documented income-driven student loan payment rather than 1% of the balance. One will accept a CPA-prepared expense statement on a bank statement loan instead of forcing a flat 50% expense factor.

The rate sheets across our panel rarely differ by more than an eighth. The guidelines differ by whole categories of borrower.

When we look at a file, the first question is not who is cheapest. It is who says yes. Then, among the lenders who say yes, who is cheapest. Doing those two steps in the wrong order is how people end up with a decline letter and a bruised credit report.

How to find out whether an overlay stopped you

You are entitled to a statement of specific reasons for an adverse action. Ask for it in writing. Then compare the stated reason against the published program guideline. If the letter says your score was insufficient and the program floor is well below your score, you have found an overlay.

1. Request the adverse action notice with specific reasons, in writing
2. Ask directly whether the decision came from the automated findings or from an internal policy
3. Ask for a copy of the automated underwriting findings, which you are usually able to receive
4. Take all of it to a broker and ask which panel lender does not have that overlay

What that borrower with the 611 did next

We placed the file with the government specialist on our panel, which publishes an FHA floor of 580 with two months of reserves below 620. The borrower already had the reserves. Approved in three business days, closed 26 days after the contract, at 3.5% down (sample figures).

Nothing about the borrower changed. Nothing about the property changed. The only thing that changed was which rulebook the file was measured against, and that is a choice somebody should have given them the first time.

All figures in this article are sample figures for illustration only. They are not an offer of credit and not a commitment to lend.