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When you apply for a mortgage, it is the lender’s job to make sure you can afford it. However, this wasn’t always the case. Between 2003 and 2006, a substantial percentage of mortgages were made without documentation or with little documentation.
Today, the story is quite different. So-called “no-doc” mortgages have all but disappeared from the industry. In this article, we’ll take a look at why no-documentation loans have lost favor and what options there are for people who have difficulty meeting traditional documentation of income and asset requirements.
The idea behind no-documentation mortgages
To qualify a mortgage, you generally need to let your lender know what your income and assets are, so the lender can determine whether you are able to pay back the loan. You’re usually asked to back up your numbers with proof in the form of your W-2s, tax returns and bank statements.
But there are some borrowers whose financial and employment situations make these kinds of documents hard to come by. These can include the self-employed, people who rely on investment income and even salespeople working on commission.
For these people and many others, proving income can be more difficult — maybe even impossible. This is why lenders began to develop a mortgage underwriting process that didn’t require proof of income, also known as as a no-documentation loan. It’s also sometimes called a stated income loan, because the borrower’s income is stated, but not proven.
However, as housing prices continued to climb in the early 2000s, the use of no-documentation and low-documentation loans spread.
“No-documentation loans are a product that was created for one purpose and started getting used for another purpose,” said Tendayi Kapfidze, chief economist at LendingTree, MagnifyMoney’s parent company. “And that led to a lot of trouble.”
No-documentation loans and the mortgage crisis
While many people understand the role that subprime mortgages played in the mortgage crisis, they may not realize mortgages issued without financial documentation also played a role.
One reason so many no-documentation loans were issued is that lenders and buyers all expected real estate prices to continue to rise, which in turn would result in increased equity. That equity would allow buyers to eventually refinance into loans they could actually afford to pay; it didn’t matter as much whether the borrower could pay back their original mortgage. “New buyers were less and less prepared for homeownership,” Kapfidze said.
When housing prices fell during 2007, many no-documentation buyers ended up underwater in loans they couldn’t pay. Meanwhile, lending standards tightened, removing the possibility of refinancing, eventually more than doubling the foreclosure rate across the country.
Dodd-Frank and the fall of no-documentation loans
No-documentation mortgages are mostly not an option for borrowers today — that’s thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act resulting from the financial crisis. One part of this law requires that lenders ensure a consumer’s ability to repay a mortgage loan before approving them. The Dodd-Frank Act’s “ability-to-repay” rule lists eight criteria that underwriters are required to consider when measuring a borrower’s capacity to afford a potential loan.
- Income and assets
- Employment status
- Monthly payment
- Child support
- Credit history
- Residual income
The Dodd-Frank act further states that a lender is required to verify these criteria using third-party resources that are “reasonably reliable.”
Getting a no-documentation home loan today
Though no-doc loans are mostly gone, there are still some flexible mortgage options available for people who have problems proving their income.
The first step to getting a “stated-income” loan in today’s lending environment is to be the right type of borrower, and that means having a high credit score and a large down payment. These stated income loans aren’t exactly like their no-documentation predecessors — they require a peek at a borrower’s assets in order to satisfy the ability-to-repay requirement, usually in the form of bank statements or portfolio statements.
In rare cases, going through a private lender could also provide an alternative option. Individuals, estates and trusts that act as mortgage originators for three or fewer properties in a year can be exempt from the ability-to-repay requirements.
In either case, be prepared to pay a higher interest rate — because of the risk associated with this type of lending, borrowers may pay a higher interest rate when securing a stated-income loan.
“As long as it’s used carefully, it can be a good loan product,” Kapfidze said.
Improving your chances of loan approval
Having a hard-to-prove income history doesn’t have to stand in the way of your homeownership aspirations. There are other things you can do to better your chances of getting a loan.
Maintain a high credit score. By keeping your debts low, paying on time, and limiting the amount of new credit you apply for, you can achieve and maintain a high credit score. The higher your credit score, the lower the risk you are to a lender. A high credit score makes you more likely to get approved and to get more favorable loan terms.
Manage your debt-to-income ratio. Your debt-to-income ratio is a measure of your current monthly debt repayments against your income. The lower the ratio is, the more income you have to take on new debts, and the more favorably a lender will look at you. For a loan to meet the general qualified mortgage status, a borrower needs a debt to income ratio no higher than 43%.
Save up for a larger down payment. The higher a down payment you can afford, the less you’ll need to borrow and the less risk the lender takes on; this makes approval easier.
Watch your business deductions. Business owners generally look to their expenses as a way of lowering their overall income and, as a result, their tax liability. But this lower income can actually hurt them when it comes to applying for a mortgage — instead, business owners may want to limit the types of deductions they take in the two years leading up to their home purchase.
Prepare your documents. If you already know that confirming your income is going to be difficult, consider spending some time prepping the documentation that underwriters may ask for. This includes gathering two years of tax returns, bank statements, portfolio statements, retirement account statements, and letters of explanation to describe reasons for credit report gaps and negative factors.
What the future may bring for alternative mortgage documentation options
If you’re hoping for a resurgence of low- and no-documentation loans in the coming years, don’t hold your breath. “It was an innovation that proved itself to not work well under duress,” Kapfidze said.
But that doesn’t mean lenders won’t develop more creative, yet compliant, ways to evaluate a borrower’s income and determine their ability to repay. In the coming years, we could see more options — “I think there will probably be some innovations in that space,” Kapfidze said.