Low Credit Score Home Buyers Could Qualify Due to a New FHA Policy

Low Credit Score

What Is the FHA Credit Score Criteria for 2020?

The Federal Housing Administration, or FHA, requires a credit score of at least 500 to buy a home on an FHA loan. A minimum of 580 is expected to make a minimum down payment of 3.5 percent. Many borrowers, however, need a score of 620 to 640 to apply.

Thanks to a revised FHA regulation, real estate lenders seem to have started to reduce their FHA minimum credit score requirements beginning in 2017, opening homeownership to thousands of home buyers.

In spite of low-to-average credit ratings, FHA loans have allowed thousands of home buyers to complete their purchase.

FHA has already adopted a strategy that could open the floodgates with potential home buyers racing to the real estate market.

Analysts estimate that the move will encourage an extra 100,000 families annually to buy a home with an FHA loan.

Since its inception in 1934, the FHA loan system has helped more than 40 million families purchase or refinance homes. Its intense success is a direct result of its versatility. The system was built from the ground up to encourage homeownership within a segment of the community who would otherwise not participate.

FHA Defeats Flexibility of Conventional Loans

There is no denying that the mortgage giants Fannie Mae and Freddie Mac have a position on the market along with their conventional loans. However, they are not very versatile with respect to other loan conditions. FHA bridges the holes by giving mortgage permits to people with :

  • Medium to low credit
  • Lower income
  • Income from multiple outlets
  • Co-borrowers who do not expect to stay in the home (non-occupied co-borrowers)
  • Down payment gift money, but no down payment on their own
  • Homes that are in need of maintenance

Without FHA, millions of homeowners will be waiting for rent years longer than they should have. But there is still room for FHA to extend its ability to support more motivating homeowners.

FHA Lenders Don’t Meet FHA Credit Score Minimums

Banks and mortgage firms selling FHA loans are not expected to obey the FHA guidelines completely.

These are private, non-profit organizations who actually accept loans on the basis of the requirements issued by the government department, primarily the Federal Housing Administration.

Most, if not all, lenders around the country lay down tighter rules for FHA loans than FHA itself does. It doesn’t seem to make any sense until you remember that FHA penalizes lenders for accepting so many poor FHA loans.

FHA also penalizes lenders if they accept borrowers who default months and years later, even though the loan suits well with FHA’s written guidelines.

Here’s an example of this.

An applicant applies for a loan and is accepted on the basis of the FHA guidelines. Six months later, he loses his employment position and can no longer afford his bill. FHA reports the bad loan on the lender’s ledger.

Too many poor loans, and FHA could revoke the right of the lender to provide FHA loans. That could bring some mortgage firms out of business.

Statistically, borrowers with lower credit ratings default more often than not. That’s why most lenders ask for a higher minimum credit score than FHA does.

Here are the credit score minimums as stated by FHA:

  • Credit score at or above 580: eligible for 3.5 percent down payment
  • Credit score of 500-579: must be reduced by 10 percent but still eligible
  • Credit score below 500: not eligible for FHA financing

Most lenders require a score of at least 620-640. But that number could be closer to FHA’s reported minimums due to the new regulation.

What was the FHA Regulation Update?

FHA also applied another tier of appraisal to their new system of defining high-risk lenders.

Former regulations

The only approach used by the former FHA strategy was to equate the FHA lender to other FHA lenders in the same geographical area. That is known in the banking community as the “compare ratio” of the FHA.

Because the lender has 150 percent more late-paying loans than other area lenders, there was a possibility of being removed from the registry of FHA-approved lenders.

Many banks and mortgage firms had problems with this process. If local lenders had higher FHA quality requirements and thus a better loan record, other region lenders would look comparatively bad.

Theoretically, the FHA lender could be shut down as the FHA lender across the street raised the minimum credit score threshold from 640 to 680.

This may and did lead to an increase – lenders increased their minimum FHA credit score criteria as high or higher than their rivals. FHA’s own policies counteracted its goal to provide less-than-perfect borrowers with access to homeownership.

Updated Policy

Although FHA is not halting the “compare ratio” process in every way, it introduces another layer of assessment.

Now, FHA will take a stand-alone look at late-paying loans focused on borrowers with a credit score of :

  • Lower than 640
  • Between 640 and 680
  • More than 680

How does that benefit borrowers with lower scores?

The lender would not be at risk of losing FHA certification because its lower credit score is close to that of loans within the same credit score bracket. In addition, the comparison should be made taking in account the whole country, not only in the regional area of the lender.

Here’s how it would look like in real life. Lender X offers 100 loans to borrowers, all of whom are below 640 score-wise. Three borrowers stop making their payments, handing Lender X a 3% “bad loan” rating.

Lender Y offers 100 loans across the street to borrowers with ratings above 680. Just one of them doesn’t pay his debt, giving Lender Y a default rate of 1%..

Under the old law, Lender X can be in trouble. His “compare ratio” is 300 percent β€” twice the appropriate standard. At this point, Lender X is raising its minimum FHA credit score to 680.

Under the new rules, Lender X could be perfect as FHA compares its default rate to the national average for borrowers with credit scores below 640.

Now, Lender X will continue to help underserved home buyers in accordance with FHA’s core mission.

To conclude, this new policy may help to maintain the number of lenders available to borrowers with credit scores that do not meet the minimum criteria for non-FHA loans.

When Can Lower Credit Score Borrowers Apply for FHA?

The new regulation has been in effect for a few years (since 2017), and your preferred lender could have already changed his internal policies. But some of them are reluctant to follow the new rule.

Usually, there is a step-down trend across the lending system. One lender will relax the rules somewhat, followed by others, before the majority act in the same way. If the new requirements work, the lenders loosen up a little more.

Lower credit home shoppers can get several offers and call various lenders around. One lender may be an early adopter of new initiatives, while another is hoping to see feedback from the rest.

Lenders are following FHA’s new approach, or it is likely they will do so. Thousands of renters who have been shut out of homeownership due to an poor history of credit may potentially apply.