VA Residual Income Guideline Is Not A QM Solution For Community Banks

By: Alice Alvey, CMB

August 4, 2014

As community based lenders look to develop their non QM products, compensating factors become the central focus when considering credit policy that permits a Debt To Income (DTI) ratio above 43%. For borrowers with years of monthly payments in reserves, the question still becomes how high of a DTI is too high? In an effort to determine the borrower’s actual cash flow lenders turn to the residual income test. The Ability To Repay rule specifically does not endorse one method when calculating the residual income of a borrower. The Bureau states a lender may look at governmental standards but may (and should) take other factors into consideration (1).

The Urban Institute published a paper titled “VA Loans Outperform FHA Loans. Why? And What Can We Learn?”. This fact filled paper is comparing FHA and VA eligibility and underwriting criteria to a conclusion that the CFPB and others should consider VA’s residual income calculation as a compensating factor. The authors surmise that the VA residual income calculation is a key to the VA’s lower default rate when compared to FHA. The problem with this approach is that it doesn’t address the differences between VA and typical non QM credit criteria used by community banks. The fact remains that the default rate of VA loans in all categories are still higher than most community bank balance sheets can handle.

Ask the credit risk officer at a community bank what foreclosure rate they strive for and the answer is <1%. The 21st ABA Real Estate Lending Report survey states, “ The average delinquency rate for single family mortgage loans, at surveyed banks, decreased from 2.40 percent in 2012 to 1.87 percent in 2013, while foreclosure rates dropped from .98 percent to .73 percent.” 78% of the 208 banks responding to the survey have less than $1B in assets. The data was collected from January 25 to February 28, 2014.

On the other hand, the delinquency rates for VA loans rose from the last quarter by 12 basis points to 5.41 as reported by the MBA Delinquency Survey May 2014 and the foreclosure inventory rate for VA loans was at 1.68%, more than double what a community bank is used to handling per the ABA survey. Delinquency and foreclosure rates are the core statistics banks must use to defend its non QM credit policy. VA performance numbers would spell failure for a community banker’s overall foreclosure rate.

The VA residual income test may be a factor in better performance over FHA but it does not support the delinquency and foreclosure rates that a community bank must defend when setting credit policy. VA loans have many factors that help performance such as the impact of military training, loyalty and oversight every borrower experiences, VA’s control over the appraisal process and appraisers, VA concentration in certain geographic markets near military installations and VA servicing requirements. Community bankers don’t have all of these factors to consider and must rely on the performance history and the economic cycles of their region and customer base.

Another key point about the VA residual income test is the fact their guidelines for balance available for family support haven’t changed since 1997. In 17 years I know a larger portion of my paycheck is going for gas, groceries, utilities and the kid’s extracurricular activities. VA’s residual income guideline for a family of 4 in the Midwest and a loan amount above $80,000, is about $1000. The Bureau of Labor Statistics CPI inflation calculator (2) indicates this is actually $1487 today. Any lender considering a residual income amount should at least adjust for inflation since the publishing of the VA guidelines and add VA’s maintenance cost of 14 cents per square foot of the home to the debts.

Another important aspect of the VA residual income calculation is its relationship to the DTI. A VA loan with a DTI over 41% must have residual income at least 120% over the published guideline. Most lenders interested in applying the residual income test are trying to offset a DTI over 43%. A non QM product with a DTI over 43% will need to proportionately adjust the guideline. Adjusting the residual income by 20% is not a magic calculation for any DTI. The lender must be able to defend that its increase of the guideline is adequate based on its historical trend information.

Community bankers should consider company specific historical and conventional lending standards to guide their use of a residual income calculation. Historical information can include the DTI in relationship to the borrower’s cash reserves and payment experience with the bank through good times and bad. This takes research and can be painful for many small lenders who have no framework to their underwriting standards. Conventional standards for residual income have developed a reference point that includes minimum amount of reserves in conjunction with residual income between $800 and $2500. Conventional markets are not inclined to accept residual income below 800 but VA’s guideline is as low as $390 for a single person with a loan amount under $80,000. This is a significant difference when qualifying lower income borrowers. This also illustrates the gap between a guideline used by secondary market lenders and the VA guaranteed product.

One community banker, working on its non QM loan policy, established a residual income grid that included home value, citing that more expensive homes require higher maintenance and utilities in their market. Another bank used the VA guideline as its foundation, raised it based on the CPI and MSA information, and then added hard stops at specific DTIs and reserves. A third lender added steps in servicing for the higher risk borrowers. In all cases, the lender will continue to test their methodology as the loans become seasoned and the policy is applied to various scenarios. The seasoning and monitoring will be the true test of what residual income guideline performs well.

The CFPB got it right when they allowed lenders to establish their own criteria for compensating factors and the use of residual income in manual underwriting. This approach allows community lenders to apply their knowledge of the market and continue to serve the customers they have come to know.

(1) 1026.43(c)(2)(vii) Section by section analysis
(2) http://www.bls.gov/data/inflation_calculator.htm