Lenders base your interest rate on the risk of default you pose. That’s why conventional loans and government-backed loans often have lower interest rates than alternative documentation loans. Fannie Mae, Freddie Mac, FHA, VA, and USDA loans all require full documentation. A lender can’t give you a loan unless you document your income, employment, assets, debts, and credit score. Lenders can tell beyond a reasonable doubt what type of risk you pose.
With alternative documentation loans, there may be a missing piece to that puzzle. While you still verify things like your income, assets, employment, and debts, you do so in an alternative format. You don’t provide your paystubs or your tax returns for example. An alternative lender is willing to accept other forms of documentation.
Keep reading to see what makes lenders give you higher rates.
Lack of Income Verification
On a fully documented loan, you provide your paystubs for the last 30 days and your W-2s/tax returns. This shows lenders verification of your income from a third party. Now if you use an alternative documentation loan because you can’t verify your income with paystubs or tax returns, you may need to verify it with bank statements. You show the lender your bank statements for the last few months that show the deposit of your income.
While your bank statements show that you have the money and that you deposited your income, it’s not the same as third-party verification. Lenders take a risk when they give you a loan based on your income according to your bank statements. While this may be perfectly acceptable for some lenders, they generally charge you a higher interest rate to make up for the higher risk of default.
Lack of Proof of Employment
Oftentimes the borrowers with a high risk of default are those that are self-employed. These borrowers don’t have paystubs to verify their income. They may have tax returns, but they often show a loss or lower income than you actually make because of the large number of write-offs that you can take. This lack of proof of income and/or employment is risky for lenders. If a lender thinks you have/make enough money to qualify for the loan, they may allow it, but with a much higher interest rate.
Lower Credit Scores
Because alternative documentation loans are a portfolio loan, lenders keep them on their own books. This means that lenders can come up with their own qualifying requirements. In other words, they don’t have to follow the Fannie Mae, FHA, VA, or USDA guidelines. This could allow a lender to give you a loan even if you have a lower credit score.
Each lender will have a specific credit score that they require, which may or may not be lower than what other loans require. If you do find a lender willing to accept say a 620 credit score, you can bet that they will charge a higher interest rate. The lower credit score lets lenders know that you are somewhat of a high risk of default. In order to make up for that risk, lenders typically charge points on the loan as well as higher interest rates.
The Overall Risk of Default
Alternative document loan lenders just take a higher irks of default. They want to avoid that risk by making sure that you qualify for the loan, but there’s still that element of risk. If you don’t have the highest credit score or you can’t verify your income for one reason or another, the lender will charge you a higher interest rate to make up for the risk that you pose.
The best thing that you can do is make sure that you minimize your risk of default. If you need an alternative documentation loan, try to increase your credit score, keep your debt ratio down, and have verification that proves beyond a reasonable doubt that you have the income to qualify for the loan.