Minimum Credit Scores on FHA Loans?

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One of the primary market benefits of an FHA loan has always been that credit scores were not a factor. A borrower with great credit scores could definitely have their loan approved more easily, but someone with some credit problems could still get approved - provided they had a well documented common sense explanation for their credit problems and could show that the problem had been resolved. In spite of not relying on credit scores, FHA foreclosure rates went down while conventional mortgage foreclosure numbers went up in spite of their almost excessive reliance on credit scores.

Then came the effective demise of the subprime mortgage market and a credit crunch in the conventional financing arena. In the mortgage industry, we started to repeatedly hear the mantra “FHA is the new subprime”. We’ve been waiting for the “modernization” of the FHA program. I’ve even been pushing that agenda myself.

Each month more of the former subprime specialists have moved into FHA mortgage origination. Unfortunately, many have also brought along their excessive reliance on loan matrices and credit grading instead of common sense analysis of the borrower’s patterns of credit usage. One of the most common questions I receive from mortgage brokers through the contact form of this website is some version of “How many late payments are allowed in the last 12 months on FHA”. I often get the electronic equivalent of a blank stare when I tell them it depends on why the payments were late. Originators who entered the market since 2000 or so aren’t accustomed to caring why a borrower’s credit is in it’s present condition.

As a result, FHA loan production has jumped precipitously in 2008. Unfortunately, many of the originators of those FHA loans have not taken the time to learn the programs. They are submitting incomplete loan packages with no credit explanations, no cover letters, often no FHA required disclosures. One of the complaints I hear constantly now from underwriters is that they are nearly having to process the loan files themselves rather than concentrate on their underwriting. Underwriting turn around times are stretching to several weeks with many lenders!

Predictably, since FHA underwriters and lenders are held responsible for defaults on the loans they approve, this deluge of applications resulted in a tightening of the underwriters’ attitudes about what they would accept. It just wasn’t worth the chance of missing something under pressure when large numbers of loans are being submitted to them by a group of people accustomed to trying to slip something by the underwriters rather than be responsible for the loan’s performance themselves.

Now the tightening has gone further. Several lenders have started implementing credit score requirements for FHA loans. This requirement started at 500, moved to 550 and now several lenders are requiring 580 credit scores. One of the latest to require a 580 score (as of March 28, 2008) is Flagstar Bank, traditionally known among FHA originators as one of the most common sense based FHA lenders in spite of their conservative outlook on the conventional side of things.

This trend is a snowball rolling downhill, because as more lenders institute this guideline lower credit score loans are going to become concentrated among the few lenders who haven’t instituted the requirement. As their ratio of low credit score loans to total originations increases, these lenders are going to be forced to institute similar guidelines in order to continue to sell their loans in the secondary mortgage market.

So, if you’re part of a young couple that listened to the wise advice of financial guru Dave Ramsey and you have no credit cards and no debt, there’s a good chance you are about to be locked out of the housing market. At least temporarily. If you’re older and you were laid off and lost your health insurance just prior to a major health problem, you may be locked out of the housing market even though you have since fixed the problem. Lenders don’t mean any personal insult in doing this. It is purely self defense.

If you’re a loan originator just now entering the world of FHA mortgage origination, these are dangerous times. Please don’t just try to wing it or rely on your processor. Get some education. Preferably get together with an experienced mentor to learn what to do. Let’s not allow this problem to get completely out of hand before we do something about it.