FHA Loans With Bad Credit – Less Likely Than in the Past

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Question: “I want to buy a home using an FHA loan, because my credit score is not good enough to qualify for a regular mortgage. But I’ve heard that lenders aren’t willing to work with people in my situation, even under the government-backed programs. Is it possible to get an FHA loan with bad credit these days?”

Update: This article was updated on August 1, 2011 with new information. There have been several changes to the program, since the article was first written. Here is the latest on bad credit FHA loans, as of 8/1/11.

Let’s start with the short answer first. After that, we can delve into the details of government-backed mortgages.

Yes, it’s possible to be approved for an FHA home loan with a bad credit score. In theory, at least. The Federal Housing Administration requires borrowers to have a FICO score of 500 or higher when using this loan program. Some FHA-approved lenders are willing to work with borrowers with credit scores as low as 500. But most will require a higher score — usually 620 or above. Your debt-to-income ratio also affects your chances of being approved (more to follow on this).

The Definition of Bad Credit

A bad credit FHA loan is a government-backed mortgage that’s given to somebody with a low credit score. But what exactly does “bad” mean in this context? Ask a dozen mortgage lenders this question, and you’ll probably get a dozen different answers. That’s because there’s not a standard definition for it. Here’s my definition:

A bad credit score is one that either (A) prevents you from qualifying for a loan, or (B) forces you to incur an interest rate that’s much higher than average. In other words, it makes mortgage financing harder to obtain, and more expensive if you do obtain it.

In the past, most people would’ve put this number at 620 or below on the FICO scoring scale. Today, I would categorize bad credit as a score of 639 below on the same scale. Why the increase? Because lenders are being more strict today than they were in the past. The housing crisis forced them to tighten their standards for mortgage approval. This applies to FHA loans as well as conventional mortgages, though it’s still easier to get approved for a government-backed loan. These higher standards are why so many people with bad credit are turned down for the FHA loan program.

Basic Requirements for an FHA Loan

Earlier this year, the FHA announced some program changes designed to minimize their risk. One of the changes applies to people with bad credit. If your score is 580 or higher, you could pay as little as 3.5% down. But if your score is below 580, you’ll have to make a down payment of at least 10%. The minimum score requirement is 500 — you need at 500 or above to be eligible for the program.

Just remember, when you apply for this program you have to meet two sets of guidelines. You have to meet the government’s minimum requirements, as well as the mortgage lender’s (often stricter) requirements. Officially, the Federal Housing Administration will allow loans to people with scores as low as 500. But many FHA-approved lenders have a higher cutoff point, often north of 600. So while you might qualify for a bad credit FHA loan in theory, you could still have a hard time getting approved for the loan.

The Rising Popularity of Government-Backed Loans

Many people with low credit scores use FHA home loans for this very reason. Generally speaking, the qualification process is easier with a government-insured mortgage than a conventional loan. The down payment is usually smaller as well. These are two of the most common reasons why people use this strategy — easier qualification and smaller down payment.

Of course, this doesn’t mean you’ll be approved automatically. You still have to go through the lender’s review and underwriting process. During this process, they will review your credit history, debts, income and other factors. If your score is too low, you might not even qualify for an FHA loan. And if you do qualify, you might have to make a larger down payment.

Bottom line: It’s generally easier for people with bad credit to qualify for an FHA loan, as compared to a conventional loan. The Federal Housing Administration insures the lender against losses resulting from borrower default. This kind of government backing makes lenders more inclined to work with borrowers with bad credit. Depending on your score, you might have to make a larger down payment with an FHA home loan.