The Federal Housing Administration (FHA) already has some of most relaxed mortgage underwriting guidelines around, but many lenders don’t originate loans based on their standards.
I often receive questions like, “I have a 600 credit score but they won’t approve me for a FHA loan. I thought you only needed a 580 score.”
Unfortunately, most banks apply overlays on top of the minimum FHA guidelines to ensure their default rates don’t get out of hand, thereby pushing them out of the program.
The FHA has been tough on lenders that exhibit default rates above their peers, using the so-called “Compare Ratio” to determine how lenders in geographic areas stack up against one another in terms of early defaults and claims.
If a lender’s performance is bad enough, their authority to originate FHA loans can be terminated.
As a result, many lenders underwrite loans well above what is required, often asking for credit scores as high as 640 when only a 580 score is needed for a mortgage with 3.5% down.
In reality, only a 500 credit score is necessary for a FHA loan if a borrower can muster a 10% down payment, but the lowest I’ve seen from a larger lender is 550.
Put simply, lenders don’t want to risk losing the ability to offer FHA loans because they took a chance on a handful of bad borrowers.
Unfortunately, this means most FHA loans go to those who don’t need them most, more creditworthy folks.
[The Typical Renter Needs an FHA Loan to Purchase a Home]
More Nuanced Approach
In an effort to combat this, the FHA has rolled out its new “Supplemental Performance Metric,” which measures a lender’s loan performance against the FHA’s risk tolerance as opposed to the performance of other lenders.
Specifically, the metric is being deployed to determine how a lender’s loans perform across three different credit-scoring tiers.
The SPM will look at loan performance for FHA loans with credit scores of 680 and higher, those with scores between 640-680, and those below 640.
Doing so will give the FHA the ability to see how a lender’s loans truly perform, as opposed to comparing apples and oranges.
For example, if a FHA lender requires a minimum credit score of 680 on all their loans, their default rate might be a lot better than their peers that accept scores as low as 600.
But that doesn’t mean they’re necessarily a more prudent lender, instead they’re just focusing on historically better borrowers.
The problem is that the FHA was designed to help borrowers who typically can’t get their hands on a conventional loan, meaning the underserved are not actually served in many cases.
Meanwhile, the brave lenders that choose to offer FHA loans with lower credit scores might be unfairly punished because their default rates will probably be higher.
In a nutshell, the SPM will complement the existing Compare Ratio to give the FHA a better understanding of how specific types of loans perform while continuing to compare lenders to one another.
In the FHA’s own words, it’s “designed to help mitigate adverse selection away from borrowers with certain credit profiles,” aka poor ones.
Hopefully this change will promote lending to a wider range of borrowers while taking the heat off lenders wary of opening the credit box.
Recently, the nation’s largest FHA lender, Quicken Loans, was sued by the United States Department of Justice for allegedly underwriting faulty loans.
This despite holding the lowest default rate of any large FHA originator in the country.
The crackdown has caused FHA lenders to become increasingly conservative, stifling efforts to reach eligible underserved borrowers the agency has pledged to help.
Long story short, look for more lenders to accept lower credit scores for FHA loans going forward. Just remember that credit is one of many factors that go into approving a loan.
There are many more reasons why you can be denied even if your credit is rock solid.