Editor’s note: The 2017 changes are still in effect in 2019. According to Ellie Mae, more lower-credit FHA applicants are being approved. In July 2016, only 19% of closed FHA loans were for borrowers with a score of 600-649; by December 2017 that increased to 23.6%. Additionally, FHA loans for borrowers with a score of 550-599 increased to 5.25% from 3% for the same date range.
In light of this, lower-credit score borrowers may want to consider a FHA loan, especially if they’ve been denied in the past.Check your FHA home buying eligibility here.
In this article:
- Required credit score for FHA loans
- Why lenders don’t follow FHA credit score minimums
- FHA policy update
- First-time home buyers and FHA loans
- Our recommended FHA lenders
The Federal Housing Administration (FHA) requires a credit score of at least 500 to purchase a home with an FHA loan. Your down payment amount plays a role too.
FHA credit score minimums and down payment requirements:
|Credit score||Down payment requirement|
|580 or above||3.5%|
|Below 500||Not eligible regardless of down payment|
Keep in mind that most lenders require a score of at least 620-640 in order to qualify despite the FHA guidelines.
Banks and mortgage lenders are private, for-profit companies that approve loans based on guidelines provided by the FHA, but are not required to follow the guidelines to the letter.
Most, if not all, lenders across the country impose tougher guidelines for FHA loans than the FHA itself. Why? Because the FHA penalized lenders for approving too many bad FHA loans even if the loan fits perfectly within the FHA’s published guidelines.
Here’s an example.
A borrower applies for a loan and is approved based on FHA’s guidelines. Six months later the borrower loses their job and can no longer make mortgage payments. The FHA records this as a “bad” loan on the lender’s record.
With too many bad loans, the FHA can revoke the lender’s ability to offer FHA loans at all. That could put some mortgage companies out of business. In addition, statistically, borrowers with lower credit scores default more often than those with higher credit scores. That’s why most lenders require a higher minimum credit score than does the FHA.
The good news: FHA has updated its policy on how it grades lenders, which should allow more lower credit score home buyers to qualify for FHA loans.See if your credit score is high enough to buy a home.
By adding another layer of lender evaluation, the FHA has a better way of identifying high-risk lenders. The change went into effect in 2017, and early analysts predicted the change could allow 100,000 additional families per year to buy a home with an FHA loan.
The Old Policy
The FHA’s sole method to evaluate high-risk lenders was to compare FHA lenders in the same geographical region — known as the FHA “compare ratio.”
Many banks and mortgage lenders had a problem with this method. If nearby lenders had tougher FHA qualification standards and therefore a better book of loans, other area lenders looked comparatively worse.
So, in theory, an FHA lender could be shut down because another FHA lender across the street raised its minimum credit score requirement from 640 to 680. This can and did lead to an escalation of sorts as many lenders raised their minimum FHA credit score requirements as high or higher than their competitors.
The FHA’s own policies counteracted its mission to provide access to homeownership to less-than-perfect borrowers.
The Updated Policy
While the FHA didn’t end the “compare ratio” method altogether, it added another layer of evaluation that provides a better metric of high-risk lenders.
Now, the FHA examines late-paying loans based on borrowers with credit scores of less than 640, between 640 and 680, and greater than 680.
How will this help FHA borrowers with bad credit?
Basically, it takes away the risk that the lender will lose its FHA credentials if its lower credit score loans are performing similarly to loans within the same credit score bracket. Also, the comparison is made nationwide, and not just in the lender’s geographical region. This means that more and more FHA lenders will be open to approving loans to those with lower credit scores.
Here’s how it might look in real life.
Lender A issues 100 loans to borrowers with scores below 640. Three of those borrowers eventually stop making their payments, giving Lender A a “bad loan” rating of 3 percent.
Lender B across the street issues 100 loans to borrowers with scores above 680. Only one borrower stops making payments, giving Lender B a default rate of 1 percent.
Under the old policy, Lender A may be in trouble — its “compare ratio” is 300 percent, which is double the acceptable level. At this point, Lender A raises its minimum FHA credit score to 680.
With the new policy, Lender A may be just fine, because the FHA now compares its default rate to the national average for loans with credit scores below 640. This means that Lender A can continue helping underserved home buyers, which is in tune with the FHA’s core mission.
Since its inception in 1934, the FHA loan program has assisted more than 40 million families purchase or refinance property. The program was built to promote homeownership among a portion of the population that would not otherwise qualify.
Conventional loans offered by mortgage giants Freddie Mac and Fannie Mae certainly have their place in the market. But, they’re not as flexible as FHA loans with certain criteria. In comparison, FHA loans offer mortgage approvals to those with:
- Medium-to-low credit scores
- Lower income
- Income from numerous sources
- Co-borrowers who don’t plan to live in the home (non-occupant co-borrowers)
- Down payment gift money, but no down payment of their own
- Properties in need of repair.
Thanks to the updated FHA policy, lenders appear to have started reducing their FHA minimum credit score requirement, which is opening homeownership to thousands more home buyers.Check your FHA eligibility now.
When should lower credit score borrowers apply for FHA loan?
When a new policy rolls out, lenders are slow to adopt it — they want to examine the results of other lenders that implemented the new guidelines. Typically, there’s a step-down effect across the lending landscape. One lender slightly loosens guidelines, followed by others. If the new standards work, lenders loosen a bit more.
And, the outlook is good. According to Ellie Mae’s Origination Report, the number of closed FHA loans with lower credit scores is rising. For example, closed loans increased to 27 percent in March 2019 from 23.6 percent in December 2017 for borrowers with a credit score of 600-649.
Regardless of credit score, all home buyers should get quotes from multiple lenders. It not only ensures that you’re getting the best deal for you, but also, especially for lower credit borrowers, that you’ll qualify. All lenders have their own rules, so just because you’re not approved by one, doesn’t mean you all will.See if you are eligible to buy a home now.