What are reserves? When are they important?
What are reserves?
Reserves, in the mortgage industry, refer to a borrower's assets AFTER the closing of a new loan. Basically, if the borrower were to lose all income, how much in reserve do they have to continue to make mortgage payments. Reserves differ from assets, because while some reserves are assets, not all assets are considered reserves.
Generally speaking, reserves are assets which a client can get access to and pull from. It can get complicated when talking about some types of assets such as retirement plans. For example, if a borrower has a 401K with $50,000 in it and there's a clause that states they can use the 401K, penalty free, for the purchase of a first home, then the borrower may use the entire $50,000 as assets toward a home purchase. However, if they are not using that 401K for the purposes of buying a home or getting a loan, a lender will only consider a percentage of the asset as "reserves". Why is this? Well, many investments can (and in 2008, did) decline drastically in value, so a lender sets these rules to protect themselves.
When are reserves important?
For most loans, the topic of reserves never really comes up, because more often than not, they're not necessary. However, they can be VERY important on iffy loan files or in some specific circumstances.
If a loan file is put into an automated underwriting system, sometimes reserves are the tipping point between a file being declined or approved, especially in instances of high debt/income ratios or low credit scores. It's important to work with an experienced lender that knows this and can work with loan files to ensure every option is exhausted when seeking a loan approval. I've seen loans get declined if I enter 3 months reserves, and approved with 6.
Since underwriting is subjective, I've always found it better to include reserves in a loan file, even if they're not needed, to make the underwriter more comfortable about a borrower and their ability to save. I don't think it's coincidence that loan approvals are usually much cleaner (Read: fewer conditions, less scrutiny of the file) when reserves are included. Remember, lenders LOVE lending money to people that don't seem to need it.
Some programs and situations actually require a specific amount of reserves in order to issue an approval. Lenders typically look at reserves on a scale of "number of months of PITI". This means that the lender will look at a borrowers savings and determine how many months of total mortgage payments (Principal, Interest, Taxes, Insurance...PITI) could be made with those savings. For example, if a borrower already has a home and is buying another property with conventional financing, they must have reserves to qualify (2 months PITI for both the home they are leaving AND the home they are buying IF they have 30% or more equity in the home they're leaving, OR 6 months PITI with less than 30% equity in the previously occupied home for both the new property & the old one...this can add up to a decent chunk of change!)
Many jumbo lenders also have reserve requirements that borrowers must meet in order to do business with them. Portfolio or niche lenders scrutinize a loan file much more than a typical conventional loan, so the more outside the box a scenario is, the more important it is to understand how reserves play a role in the process.
Want to work with a knowledgeable mortgage banker that knows how to make the process easy? Give me a call at 484.680.4852!