By Chris Hendricks, Real Estate Financing Advisor
Clearing up misconceptions and understanding just a few of the rules for mortgage underwriting may help in drafting an agreement and planning more realistically for housing the future divorcee.
Certainly one of the more important issues facing those crafting a separation or settlement agreement is where the parties are going to live. In over twenty years of originating home mortgages I have seldom worked with a recent or mid-process divorcee who has not been surprised by the way in which the terms of his or her agreement impacted their housing plans. Misconceptions and inaccurate assumptions are common.
Clearing up some of these misconceptions and understanding just a few of the rules for underwriting home loans may help in drafting an agreement and planning more realistically for housing the future divorcee.
1. In qualifying for a home loan, support payments have over twice the impact on the supporting ex- spouse most divorcees expect.
A common misconception is that one dollar of income will cover one dollar of support obligation. When it comes to mortgage underwriting, one dollar of support requires a set-aside of roughly $2.33 in income for the ex-spouse obligated to make the payment.
One of the many things that home loan underwriters examine when qualifying a borrower is the applicant’s expense-to-income ratio. The regulations that were born of the Dodd-Frank Wall Street Reform and Consumer Protection Act dictate that a borrower’s maximum allowable “expense-to- income ratio” is 43%. In other words, the sum of a borrower’s housing expenses plus monthly credit liability payments divided by his/her income should be 43% or less. The 43% limitation is a rough way of accounting for a borrower’s other expenses (income taxes, food, clothing, medical, auto, etc.). There are exceptions to this guideline, but for our purposes, 43% is a good baseline with which to work.
In qualifying for a loan, support payments are not deducted from income as most people assume, but are included in monthly liability calculations for the supporting divorcee, and therefore must be covered by income at a 43% ratio. So, if support payments are, say, $2,000 per month, then the supporting ex-spouse must have $4,651 in income just to cover the support payment (as $2,000 is 43% of $4,651). Only income in excess of the $4,651 can then be used toward carrying the borrower’s new housing expenses and monthly credit liabilities in his or her loan qualifying calculations.
2. The assignment of responsibility in a divorce decree for a jointly-held debt does not necessarily transfer all liability outside the confines of the family law courtroom.
The ongoing payment obligation and payment history of the debt assigned to one party may continue to impact the “non-responsible party” when applying for a home loan.
For example, if a judgment assigns responsibility for an auto loan, originally taken in the names of both spouses, to one ex-spouse, this does not invalidate the original credit contract, and the legal liability for this debt has not been removed from the non-assigned ex-spouse. Both parties are still obligated on this loan. If payments are not made on time, the credit reports of both parties will be impacted and the creditor can pursue both parties for any debt left unpaid.
Not only does the creditor still consider both parties to be responsible for this auto loan, but prospective mortgage lenders may also include the monthly payment for this loan in their expense-to-income ratio qualification calculations, even for the non-responsible ex-spouse. This debt is considered by the mortgage industry to be a “contingent liability”. Mortgage underwriting guidelines are inconsistent as to how contingent liabilities assigned individually in a divorce or separation agreement should be handled. Fortunately, standard agency guidelines (Fannie Mae and Freddie Mac) allow the lender to treat the liability as specified in a court-ordered decree or settlement agreement.(1) However, “Non-Conforming” Jumbo or Portfolio lenders may require the inclusion of this contingent liability, or allow the exclusion only with the combination of a court order, proof that the borrower’s ownership interest in the securing property has been transferred and/or documentation providing a six to twelve-month payment history for the subject liability by the assigned party. (2)
If payments are missed on a joint account, the credit reports and credit scores of both parties will be hurt. This can be devastating as credit scores are used to determine how much loan is offered in relation to property value, and at what interest rate.
The only way to remove a contingent liability is to pay it off and close it, or refinance it in the name of the assigned ex-spouse.
Note: To be useful in underwriting a loan, it is important that a settlement agreement clearly specify the assigned account (creditor name and full account number, and, if secured, securing property), and that the ex-spouse assigned the account be obligated by the agreement to provide the necessary documentation to the non-responsible party any documentation that might be needed to satisfy a lender’s requirements regarding this account (i.e. copies of cancelled checks or account statements showing direct payments).
3. Being removed from title to a property, but not the mortgage, removes the asset, but not the liability.
If, as part of a settlement agreement, one party gives up or grants their ownership interest in a real estate property to the other (i.e., via a quit-claim deed), but remains on the mortgage and there is no assignment of responsibility for the obligations and liabilities associated with the property, there is no way for a loan underwriter to justify removing any mortgage payment associated with the property from the grantor’s new purchase-loan qualifying calculations.
And even if the divorcee retaining the property is assigned responsibility for the mortgage, this does not necessarily remove it from the equation for the granting ex-spouse (see #2 above).
While being removed from both title and the mortgage may be preferred, this option often faces challenges. The divorcee retaining the property may not be able to qualify for the new replacement mortgage alone. Support payments may not have the qualifying power expected and cannot be used in qualifying without having been received for six months, and only if the terms of the court order indicate that they will continue for a minimum of three additional years.
Consultation with a mortgage lender who can work through the numbers associated with a particular scenario may be helpful in making clear the challenges and possible solutions.
4. Once the divorce process is started, underwriting a loan request may be difficult until such time as a binding separation or settlement agreement is reached. And if a property is being purchased separately prior to the divorce being final, a quit claim deed will need to be executed by the non– participating spouse.
In underwriting a home loan a borrower’s income, assets and liabilities must be evaluated. Once underwriting becomes aware that divorce proceedings have begun, the underwriter must account for the potential changes in income and expenses that might result. Without a binding agreement, this cannot be done. (Voluntary support payments, no matter how consistent they have been and for how long, cannot be used to determine either obligation or income.)
In most cases conventional mortgage underwriting will require a court filed separation agreement, a court order or a filed divorce decree or settlement agreement. (3)
If a property is being purchased by one spouse “sole and separate,” prior to the finalization of a divorce, the transaction cannot be completed without the cooperation of the other spouse, as he/she must “quit” his/her claim to the new house as community property by executing a quit-claim deed.
Although the following item is not directly a loan underwriting issue, it comes up frequently in originating home buy-out refinances for divorcees.
5. The “equity” in a home may not simply be the difference between the market value and the outstanding mortgage balance, and should be clearly defined in a property settlement agreement.
One reasonable definition of home equity might be: the net proceeds the owners receive from the sale of the house. If joint equity is to be separated and distributed through the sale of the home, then this is how, by default, equity is defined. But there is no equivalent default definition when one party is to retain the property and equity is to be distributed by a “cash-out” refinance.
The difference between simple equity (value less mortgage) and true or net sales equity can be substantial, as the net equity proceeds from a sale are the sales price, less the mortgage balance, less the sale closing costs. These closing costs can include:
- a) Real estate agent commission (a typical realtor fee for a residential sale is between 5 and 6% of the sales price);
- b) Escrow, title insurance, government recording and inspection fees (typically 1-2.0% of sales price);
- c) Special community assessments that must be paid by the seller (these can vary wildly and may add from 0-2%); and
- d) Property taxes which have been accumulating since the end of the previous tax period. (Property taxes may be considered a community liability until the divorce is final and are seldom addressed in a property settlement agreement.)
Without clear direction in the settlement agreement, determining the equity to be split through a refinance can become a significant dispute. When equity is defined other than simple equity, we have seen several methods utilized. One solution is the use of a flat percentage (i.e., 7%) to account for closing costs. Another is to actually estimate the amounts for some or all of the closing cost items listed above, as they can be reasonably calculated.
Chris Hendricks is a Senior Loan Officer and the Branch Manager in Westlake Village, California for Homeowners Financial Group. Chris has undergraduate and graduate degrees from Stanford and UCLA. He has been originating loans since 1994 and has specialized in helping parties to a divorce through the necessary financial and housing transition. www.chnewstartmortgage.com
(1) Fannie Mae Single Family 2015 Selling Guide: B3-6-05, Monthly Debt Obligations (06/30/2015)
(2) Wells Fargo Funding Seller Guide: Non-Conforming Underwriting Guidelines 825.09: Credit – Long-Term Debt
(3) Fannie Mae Single Family 2015 Selling Guide: B3-3.1-09, Other Sources of Income (08/25/2015) and B3-6-05, Monthly Debt Obligations (06/30/2015)