Overlays: What They Are and Why Lenders Apply Them

Written by Posted On Monday, 28 December 2020 00:00

There is a term lenders refer to as an ‘overlay’ and can be applied to most any conventional or government-backed mortgage. What exactly is an overlay? An overlay is an additional approval requirement beyond what is required by the secondary market. The secondary market is where lenders go to sell loans they’ve made to consumers. Selling a mortgage can upset borrowers who thought the lender they picked out was their lender for the life of the loan. That’s rarely the case anymore. 

If lenders didn’t have the ability to sell loans they’d soon run out of money to lend. They’re lenders no more. But being able to sell a loan replenishes the lender’s line of credit enabling it to make still more loans. Before a lender can sell a loan, or a bulk of loans, the loan(s) must meet these secondary market requirements.

Most conventional loans made today are those approved using guidelines set by either Fannie Mae or Freddie Mac. Government-backed mortgage loans must also follow specific guidelines. But an overlay is one more guideline beyond the secondary market requirements. Why do lenders set overlays? An additional approval requirement means the loan is even more secure. 

A good example might be for credit score requirements. While a secondary requirement might ask for a minimum 680 credit score, a lender can place an overlay and require the minimum score be 700. Or, a minimum down payment requirement for an investment property could be 20% but an additional overlay might ask for a 25% down payment. Overlays decrease the risk in a lender’s portfolio.

Further, different lenders set their own internal overlays. An overlay at one lender can mean another lender doesn’t ask for the very same requirement. This gives consumers choices. Many consumers however might falsely think that overlays are universal. For instance, someone applies for a mortgage and discover the qualifying credit score is 700 and their score comes up to 690. Unfortunately, some consumers can make the determination they can’t qualify for a mortgage because they discover their scores are 10 points lower than what is required. When all they needed to do was find another lender that asks for a minimum 680 score.

Overlays can be issued to decrease some of the risk lenders acquire issuing a mortgage but what overlays can’t do is issue an overlay that makes the loan easier to qualify for. Maybe an overlay might say a minimum score required is 670. While a lender can certainly authorize such an overlay the loan will then be ineligible to be sold in the secondary market. This would then mean the lender would be forced to keep the loan internally and collect the monthly payments. This is called ‘portfolio’ lending and very few mortgage companies keep mortgages for the life of the loan but instead arrange for a sale. This liquidity keeps the mortgage industry running.

Lenders can also reverse an original overlay at their discretion. A lender might decide to increase its minimum credit score requirement to 700 but a year later decide the market has stabilized and the risk of defaults are very low and lower the required score back down to 680. A lender has the ability to issue an overlay but has the authority to change its mind at any time.

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David Reed

David Reed (Austin, TX) is the author of Mortgages 101, Mortgage Confidential, Your Successful Career as a Mortgage Broker , The Real Estate Investor's Guide to Financing, Your Guide to VA Loans and Decoding the New Mortgage Market. As a Senior Loan Officer and Mortgage Executive he closed more than 2,000 mortgage loans over the course of more than 20 years in commercial and residential mortgage lending. 

He has appeared on CNN, CNBC, Fox Business, Fox and Friends and the Today In New York show. His advice has appeared in the New York Times, Parade Magazine, Washington Post and Kiplinger's as well as in newspapers and magazines throughout the country. 

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