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How a Collection Account Could Kill Your FHA Loan Approval

road closed

There’s been a lot of hubbub lately about a new rule that was supposed to go into effect on April 1.

I say “supposed to” because the FHA has since rescinded the rule, at least until July 1, and is now asking for public comment to get their head around it all.

My guess is that it will be overturned, and things will go back to how they are now, but only time will tell.

The Rule in Question

In short, the new underwriting rule requires prospective FHA loan holders to pay off any collection or combination of collections that totals more than $1,000.

So if you happened to have an erroneous medical collection, or were currently disputing a credit card collection, you’d have to settle it before receiving your FHA loan.

Even if the charge happened to be bogus, if you wanted an FHA loan, you’d either have to pay the collection off in full or setup a payment plan with the collection agency (and make three verifiable payments).

Those payments would also factor into a borrower’s debt-to-income ratio, which could limit or jeopardize the mortgage.

Put simply, you’d have to make a commitment to pay off the debt in order to qualify for the mortgage.

In the past (and I suppose currently), the FHA did not require that collection accounts be paid off as a condition of mortgage approval (unless it was a court-ordered judgment).

Sure, underwriters would still need to take a look to see what it was and how it might impact the issuance of a mortgage, but it wouldn’t be an outright roadblock.

Why the New Rule is a Problem

The new rule is problematic for a couple reasons. I suppose the biggest issue is that FHA loans were originally intended for lower income borrowers with little money set aside for down payment.

So those with sizable collection accounts, and presumably little cash on hand, would probably have difficulty paying off the debts while having enough money leftover for down payment, closing costs and future mortgage payments.

Along with that, the rule essentially forces would-be borrowers to pay off the collection account(s), even if they aren’t legit. Or if they are currently in dispute.

There are plenty of erroneous collections out there, so forcing borrowers to settle them isn’t necessarily fair.

*The FHA excludes disputed accounts or collections resulting from identity theft or unauthorized use if appropriate documentation is provided.

All that said, this is a good lesson for first-time homebuyers and current homeowners alike to stay on top of their credit.

That means ordering a credit report several months before applying for a mortgage to see where you stand, and also to ensure that nothing is reporting in error (or legitimately) that could hold you back from obtaining a mortgage.

After all, you don’t ever want to limit your options when it comes to getting a mortgage.

Read more: What credit score is needed for a mortgage?

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