5 Reasons Why FHA Loan Applications Get Rejected

The Federal Housing Administration’s loan program is incredibly popular among home buyers these days. In many ways, FHA loans are a last resort for borrowers who get turned down for conventional or “regular” mortgages.

But the FHA program is going through many changes lately. Standards are getting higher, and so are the costs associated with these loans. As a result, there is no guarantee you can get approved for an FHA loan. Just ask the thousands of people who get turned down for the program every year.

Why FHA Borrowers Get Turned Down

There are more than a dozen reasons you could be denied an FHA loan. But some factors are more common than others. Here are the five most common reasons why FHA applications get rejected.

1. You lack the funds for a down payment.

Current guidelines issued by the Department of Housing and Urban Development (HUD) require all FHA borrowers to put down at least 3.5% of the loan amount. This requirement immediately rules out borrowers who simply lack the cash reserves for a down payment.

VA and USDA loans are the only options for 100% mortgage financing these days. Conventional loans require a minimum of 5% down, and sometimes as much as 20%. The Federal Housing Administration requires at least 3.5%. So if you can’t come up with at least 3.5% of the loan amount, you’ll likely be turned down for an FHA loan.

2. You don’t have enough money to cover your closing costs.

The down payment is only one of the upfront expenses you’ll encounter. You’ll also have to pay closing costs on the loan, and these can add up to thousands of dollars. Granted, the FHA allows sellers to contribute a certain percentage of the purchase price toward the buyer’s closing costs.

But these so-called “seller’s concessions” are becoming more and more rare in today’s real estate market. Many cities cross the country are transitioning from a buyers’ market to a sellers’ market. And in a sellers’ market, homeowners are unlikely to make such concessions. After all, they have all the leverage.

When you apply for an FHA loan, the lender will check to see how much money you have in the bank. If you don’t have enough to cover your down payment and your closing costs, you could be denied the FHA loan.

3. You have too much debt.

The debt-to-income ratio, or DTI, has become one of the most important mortgage qualifications in 2013. This is when lenders compare your gross monthly income to your monthly expenses (recurring debts such as credit card bills, car payments, and the like). The DTI limits vary from one lender to another, and also depending on the type of loan you use.

When it comes to FHA loans, the 43% rule has emerged as the new “gold standard.” If your total debt-to-income ratio exceeds 43%, you could have trouble getting an FHA loan. You might not be turned down entirely. But you’ll face a more rigorous underwriting process.

4. Your credit score is too low.

There are three official credit-score limits within the FHA loan program:

  • HUD requires borrowers to have a credit score of at least 500 to be eligible for the program.
  • To take advantage of the 3.5% down-payment option, you’ll need a score of 580 or higher.
  • A new rule for 2013 has set an additional bar at 620. In short, borrowers with credit scores below 620 and debt ratios above 43% must undergo a manual (i.e., more intensive) underwriting process.

Additionally, the mortgage lender may impose its own credit score guidelines on top of those issued by HUD. This scenario is so common there’s a name for it – lender overlays. The lender can reject your FHA application even if your credit score falls within HUD’s guidelines.

5. You’ve been foreclosed on recently. 

HUD has specific guidelines regarding previous foreclosures. If you’ve been through foreclosure within the last three years, you will probably be turned down for an FHA loan. The official guidelines state that borrowers may be eligible for the program if three years have passed since they were foreclosed upon, and only if the borrower has reestablished good credit in that time.

According to a recent HUD press release:

“Borrowers are currently able to access FHA-insured financing no sooner than three years after they have experienced a foreclosure, but only if they have re-established good credit and qualify for an FHA loan in accordance with FHA’s fully documented underwriting requirements.”

These are not the only reasons why FHA loans get rejected. But they are some of the most common scenarios. Sometimes it’s a single factor that leads to rejection. For instance, a borrower with too much debt can be turned down for a mortgage, even if he or she meets all other program requirements. In other cases, it’s a combination of factors that leads to rejection.

Read: FHA loan turned down in underwriting

Here’s what you should take away from all of this. The FHA loan program has long been seen as the last refuge for poorly qualified borrowers. But times have changed. The Federal Housing Administration has suffered massive financial losses, resulting from the housing crisis. As a result, they have tightened their standards across all aspects of the program.

FHA mortgage rejections are much more common today than they were in the past. In order to qualify for the program, you must be able to demonstrate your financial responsibility, and you must have a certain amount of money in the bank. There is no way around this. Welcome to the new economy.

Proposal: Bigger Down Payments on FHA Loans Above $625,500

The Federal Housing Administration is still reeling from financial losses resulting from the housing crisis. As a result, the agency is looking for ways to reduce risks and shore up its capital reserves. In support of these goals, the Department of Housing and Urban Development (HUD) has announced a series of changes to the FHA loan program.

The latest rule change has to do with down payments on FHA loans larger than $625,500. Specifically, HUD has proposed raising the minimum down payment for government-insured loans over $625,500 from 3.5% (the previous standard for all FHA loans) to 5%.

Stated differently, the maximum loan-to-value (LTV) ratio for these larger loans would fall to 95%, compared to 96.5% previously. This is the latest in a series of steps designed to minimize risks and increase revenue.

5% Down Payment for Larger Loans

According to the Federal Register notice:

“This notice proposes to set a 95 percent maximum LTV for FHA-insured loans over $625,500, with certain exemptions … HUD has determined that this proposed change to the LTV requirements is necessary to improve the health of the MMIF [Mutual Mortgage Insurance Fund]…”

There was no explanation on what ‘exemptions’ would be allowed.

The comment period for this proposal ended earlier this month. This is typically the first step in a process that ultimately leads to a permanent rule change. Barring any major outcry from lenders and housing advocates, we expect this rule to be passed.

3.5% for All Other FHA Loans

The minimum down payment on FHA loans equal to or less than $625,500 would remain unchanged at 3.5%. This is the primary appeal of the FHA program. Home buyers who lack significant cash reserves often use government-insured mortgage loans to minimize their down payment expense.

Most conventional loans these days require at least 5% down, and sometimes as much as 10%. High-risk borrowers with financial troubles in their past are often required to put down as much as 20%. So the FHA program frequently becomes a last resort for borrowers who lack down payment funds.

A Series of Program Changes

HUD has implemented a number of additional rules in 2012 and 2013. For instance, they have increased the mortgage insurance premiums (MIP) borrowers must pay when using an FHA loan. They have also implemented some new rules regarding credit scores and debt ratios.

These are not the first changes to the program, and they probably won’t be the last. The 5% down payment requirement for FHA loans above $625,500 is indicative of a larger problem within the Federal housing Administration. This federal agency is required to maintain capital reserves equal to 2% of its total loan guarantees. But insurance payouts stemming from the housing crisis have obliterated the agency’s capital reserves. In fact, an audit last year found the FHA to be deep into negative territory.

There have been rumors that HUD is also planning to raise the minimum down payment or smaller FHA loans. But as of right now, these are merely rumors. At this time, we see no indication of a minimum 5% down payment across the board. The current proposal specifically applies to FHA loans larger than $625,500.

Harder to Qualify for FHA

The down payment is only one obstacle to FHA financing. In most cases, borrowers will also need credit scores of 600 or higher and debt-to-income ratios below 45%.

Additionally, new rules for 2013 state that borrowers with credit scores below 620 and total debt-to-income ratios above 43% must undergo a more rigorous form of underwriting. Instead of being approved through the FHA’s automated underwriting system (known as TOTAL Scorecard), these borrowers must be reviewed by a human underwriter.

FHA borrowers must also have sufficient funds in the bank to cover their closing costs. Mortgage lenders typically verify the borrower’s financial assets at the time of application, to ensure they can cover both the down payment and the closing costs.

Note: We will update this story if and when the new down payment rule comes to fruition.

Shopping for an FHA loan? We can help you compare mortgage rates. Our weekly lender survey gives you some insight into current rates and trends.

FHA Mortgage Insurance Rises as Agency Struggles with Financial Losses

FHA loans have become the financing tool of choice for many home buyers. They offer lower down payments and more flexible approval criteria, when compared to conventional mortgages. But these loans are slowly but surely becoming more expensive and harder to obtain.

The latest change, scheduled to take effect next month, will increase the FHA mortgage insurance premium that borrowers must pay. Here’s what you need to know about it.

Borrowers who use the FHA program have to pay for two different types of insurance coverage on their loans. There is an annual mortgage insurance premium (MIP), as well as an up-front premium.

  • The up-front premium currently equals 1.75% of the amount borrowed, and can be ‘rolled’ into the loan and amortized over the term.
  • The annual premium is typically paid in 12 installments per year. It too can be rolled into the monthly payments. This is the one that’s going up in April 2013.

Mortgage Insurance Premiums Protect the Lender

Borrowers pay the cost of these premiums. But the coverage itself protects the lender. This is how the FHA loan program works. The Federal Housing Administration ensures the mortgage lender against losses that may result from a borrower default. So if the homeowner stops making the mortgage payments for some reason, the lender will be reimbursed for their losses out of the FHA’s insurance fund.

The primary benefit for borrowers is that they can put less money down compared to a conventional loan. Additionally, borrowers who get turned down for conventional financing can often get approved through the FHA program. So there are unique costs and benefits associated with this program.

But let’s get back to the FHA mortgage insurance premium.

Annual MIP Set to Increase on April 1, 2013

Starting on April 1, 2013, the annual mortgage insurance premium (MIP) for FHA loans will increase by 10 basis points, or by .10%. To see how this would affect your mortgage payments, you would simply multiply the loan amount by .0010, the decimal form of .10%.

For example, the MIP cost of a $200,000 FHA loan would go up by $200 per year. Remember, this is an annual mortgage insurance premium. So the .10% increase applies on an annual basis. (The math: 200,000 x .0010 = $200 more per year.)

The .10% increase applies to loans equal to or less than $625,500. For home loans that are larger than $625,500, the annual MIP will go up by 5 basis points, or 0.5%.

The following annual MIPs will be charged for loans with case numbers assigned on or after April 1, 2013:

Loan Term more than 15 Yrs
Base Loan Amount $625,500 or less Base Loan Amount above $625,500
LTV 95.01% or more 1.35%
LTV 95.00% or less 1.30%
LTV 95.01% or more = 1.55%
LTV 95.00% or less = 1.50%
Loan Term 15 Yrs or less
Base Loan Amount $625,500 or less Base Loan Amount above $625,500
LTV 90.01% or more = .70%
LTV 78.01% to 90.00 % = .45%
LTV 78.00% or less = 0.00%
LTV 90.01% or more = .95%
LTV 78.01% to 90.00 % = .70%
LTV 78.00% or less = 0.00%

As mentioned earlier, there is also an up-front mortgage insurance premium (UFMIP) applied to FHA loans. Despite the “up-front” name, this too can be rolled into the loan. The FHA’s current up-front premium is 1.75% of the loan amount. For example, a mortgage of $250,000 would incur a UFMIP of $4,375. This amount would be added to the loan balance, and would therefore increase the size of the borrower’s monthly payments.

The FHA has not announced any changes to the up-front premium – at least, not at this time. It is the annual FHA mortgage insurance premium that will increase on April 1, 2013.

But this doesn’t mean we won’t see additional increases down the road. In fact, the Department of Housing and Urban Development (HUD), which oversees the FHA program, has raised premiums a total of five times over the last three years. So we could certainly see additional hikes down the road, as the agency continues to rebuild its reserves.

Future of FHA Uncertain At Best

As mentioned earlier, the Federal Housing Administration insures mortgage loans against losses resulting from borrower default. So when a large number of borrowers default on their loans, the FHA suffers big financial losses. This is exactly what happened during the housing collapse that came to a head in 2008. We are still seeing the affects of it today.

Due to a congressional mandate, the FHA is required to maintain capital reserves equal to 2% of its total loan guarantees. They fell below that level three years ago. A recent audit found the agency to be deep in negative territory. This is why they are making so many changes to the program right now.

HUD has increased FHA mortgage insurance premiums several times over the last few years. But they haven’t stopped there. They’ve also implemented new rules regarding credit scores and debt ratios. All of this is an effort to protect the FHA against future financial losses, while restoring its capital reserves to acceptable levels.

Members of Congress have been pressing the FHA for change, and we are seeing some of those changes right now. The mortgage insurance premium increase is only one example of this. We expect to see additional policy changes over the coming months and years.

The housing crisis showed us that the FHA’s current model is unsustainable. As a result, the agency will continue to be analyzed, investigated and altered to protect it against such catastrophes in the future.

Catching Up With FHA: New Rules and Regulations for 2013

They’re at it again. The Federal Housing Administration (FHA) recently announced a series of changes to the FHA loan program.

The new rules and regulations are designed to shore up the agency’s capital reserves, which became severely depleted during the housing crisis. This is the latest in a series of new rules that will affect FHA borrowers in 2013.

Tough times call for tough measures.

A congressional mandate requires the FHA to maintain capital reserves above a certain level, in order to cover foreclosure-related losses. By law, the Federal Housing Administration must maintain capital reserves equaling, at a minimum, 2% of its insured loan portfolio. Last year marked the fourth consecutive year that they have failed to meet this requirement.

At the end of 2012, an audit revealed that the mortgage-backing agency had completely exhausted its reserves, falling into negative territory. They are now scrambling to recover from these losses, partly by introducing new rules and regulations on FHA loans.

2013 Brings New Rules for FHA Loans

In 2012, the FHA took steps to rebuild its reserves, namely by raising the insurance premiums it charges on the loans it insures. But those efforts were not enough to overcome mounting losses from foreclosures. The latest round of new rules, announced in January 2013, are part of an ongoing effort to keep the agency afloat. Here is a summary of the latest regulations and rule changes for FHA loans:

1. FHA Mortgage Insurance Premiums are Going Up

When you use an FHA loan to buy a house, you will be required to pay for mortgage insurance. There are two types of mortgage insurance premiums (MIPs) associated with these loans — the annual MIP, and the upfront MIP. A new rule for 2013 will bring higher premiums for borrowers using this government program.

The FHA has announced it will raise the annual premium on most new mortgages by 10 basis points, or by 0.10 percent. For jumbo loans, which are defined as $625,500 or more, the premium will go up by 5 basis points or 0.05 percent. Certain loans, such as the FHA streamline refinance, will be exempt from these changes.

Additionally, borrowers who use FHA loans will now be required to pay the annual MIP for the life of the loan. In the past, the annual premium could be cancelled when the loan’s outstanding principal reached 78% of the original principal amount that was borrowed.

An internal review showed that the agency has been losing significant revenue because of this policy, while still retaining the risk of each loan through its entire life. So the policy is being changed. The new FHA rule for 2013 states that borrowers will have to continue paying the annual MIP for the “life of their mortgage loan.”

  • This new regulation will apply to FHA loans with case numbers assigned on or after April 1, 2013.
  • Refer to HUD Mortgagee Letter 2013-04 for more information.

2. Manual Underwriting for Borrowers with Credit Scores Below 620

In 2013, borrowers with credit scores below 620 and combined debt ratios above 43% will face additional scrutiny. Such borrowers can no longer be automatically approved through TOTAL Scorecard, the FHA’s automated underwriting system. Instead, borrowers who fall into this range must be carefully reviewed by a human underwriter. Lenders must find and document compensating factors to support their approval of such borrowers.

A list of compensating factors can be found in HUD Handbook 4155.1, Section 4.F. Compensating factors include a larger down payment (10% or more), substantial cash reserves, or a history of making mortgage payments equal to or greater than the payments on the new loan. Having an excellent credit history / score will also work in the borrower’s favor.

  • This new rule will apply to FHA loans with case numbers assigned on or after April 1, 2013.
  • Refer to HUD Mortgagee Letter 2013-05 for more information.

3. Larger 5% Down Payment Required on FHA Loans above $625,500

For most FHA loans, the minimum down payment is 3.5% of the amount borrowed. This is what the borrower has to pay, in order to be approved for the program. It’s an appealing feature that attracts many borrowers to the program in the first place. A proposed new rule would raise the down-payment requirement for larger mortgages.

If enacted, this rule will apply to “jumbo” mortgages with original principal balances higher than $625,500. For a loan of that size, the borrower would be required to make a down payment of at least 5% of the amount borrowed. We expect to hear more on this subject within the next few days. FHA officials said they will release additional details in a forthcoming Federal Register Notice.

4. FHA Loans after Foreclosure: Three-Year Rule + Good Credit

Update, September 2013: HUD shortens post-foreclosure waiting period to 12 months for some borrowers.

This is not so much a new rule as a tighter enforcement of an existing rule. The Federal Housing Administration, and its parent organization the Department of Housing and Urban Development (HUD), have specific rules about using an FHA loan after a past foreclosure.

In short, the rule states that borrowers may be eligible for an FHA-insured mortgage “no sooner than three years after they have experienced a foreclosure.” But the borrower must have rebuilt his or her credit score since the foreclosure took place, and must meet all other requirements for an FHA loan. In other words, the three-year rule is only a minimum requirement.

An investigation found that some lenders were engaging in misleading advertising, by telling borrowers they could “automatically” qualify for FHA loans after the three-year mark. Officials state this is not true, and that borrowers with a previous foreclosure must be fully reviewed in accordance with current underwriting requirements. There is no “automatic” approval at the three-year mark.

Over the coming weeks, we expect to receive additional information regarding FHA loan rules and regulations for 2013. There is even talk of a bailout for the troubled agency. But that’s another story entirely.

620 Credit Score Reemerges as Mortgage Threshold in 2013

credit score 620A new rule for FHA loans will take effect in 2013. Borrowers with credit scores below 620 will face additional scrutiny in the area of debt-to-income ratios.

In a previous story, I explained that 600 was a key credit score for FHA loans. That statement was based on a questionnaire we sent to more than two-dozen mortgage lenders.

We asked them about their minimum qualification standards for FHA loans. Most said they would grant FHA loans for borrowers with credit scores down to 600. Today, the same is true — 600 is still the rule of thumb for many lenders.

But a new rule could raise the bar to 620 for certain borrowers. Here’s what you need to know about it.

Tough Times for Housing Agency

The Federal Housing Administration (FHA) is currently grappling with financial losses stemming from home foreclosures. During the housing collapse, record numbers of homeowners defaulted on their home loans. Many of those loans were insured by the FHA. As a result, the agency suffered huge losses that have wiped out its financial reserves.

According to an independent audit released in November 2012, the agency’s projected losses hit $16.3 billion at the end of September 2012. In fact, the agency could soon require taxpayer funding to stay afloat, for the first time in its 78-year history. This has many on Capitol Hill worried. A bipartisan group of senators is now pressing for serious reform at the FHA. And they’re getting it.

In 2011, the Department of Housing and Urban Development (HUD), which oversees the FHA loan program, raised the insurance premiums that borrowers must pay. That was the first in a series of steps to bolster the agency’s capital reserves, and to protect it from further losses. They’ve also tightened up the qualification standards for FHA loans. The latest change has to do with credit scores.

New for 2013: The 620 Credit Score Rule for FHA Loans

In a letter to Senator Bob Corker (one of many in Congress pressing for change within the agency), FHA commissioner Carol Galante wrote the following:

“FHA … will require borrowers with scores below 620 to have a maximum debt-to-income [DTI] ratio no greater than 43 percent … If a borrower’s DTI exceeds 43 percent, lenders will be required to manually underwrite the loan.”

Translation: Borrowers with credit scores below 620 will face an additional hurdle during the application and review process. If a borrower in this range also has a debt-to-income ratio higher than 43 percent, he or she will have a harder time qualifying for the loan. An underwriter will step in to give the application package a closer inspection (i.e., manual underwriting). What happens next will depend on the strengths and weaknesses of that particular borrower — employment, down payment, other assets, etc.

This is not to suggest that borrowers with credit scores below 620 are out of luck. Many lenders will approve borrowers below that mark, as long as their income and employment check out okay. But we are seeing a clear trend where more and more lenders are setting the bar at 620. This has been true for conventional mortgages for some time. Now it’s true for FHA loans as well.

How to Raise Your Score

Credit scores are not arbitrary. They are derived from the information found within a person’s credit report. While there are many factors that can influence these scores, it mostly comes down to one thing — how you repay your debts.

Consumers with a long history of paying their bills on time typically have high credit scores. This helps them qualify for all kinds of financing, including mortgage loans. It also helps them secure lower interest rates on financing, which can be a real money-saver.

In contrast, consumers who are frequently late or delinquent in paying their bills typically have low scores. Lenders and creditors see them as high-risk borrowers. This makes it harder to qualify for mortgage financing. If you fall into this group, you should make every effort to raise your credit score before applying for an FHA loan — or any type of mortgage, for that matter.

Read: How to improve your credit score

You can boost your score by paying all of your bills on time going forward. This is huge, because your payment history accounts for 35% of your overall credit score. Reducing your credit card debt may also help, especially if you’re nearly maxed out on one or more of your cards. See the link above fore more tips.

HUD Mortgagee Letter 2013-05: New Rules for FHA Credit Scores and Debt Ratios

On January 31, 2013, the Department of Housing and Urban Development (HUD) issued a new rule for all FHA borrowers. According to HUD Mortgagee Letter 2013-05, applicants with credit scores below 620 and debt-to-income ratios above 43% must undergo a stricter form of manual underwriting, prior to approval. This could narrow the eligibility window and put financing out of reach for some borrowers.

These days, FHA loans are one of the most popular financing tools for home buyers. They are especially popular among first-time home buyers. A 2012 survey found that more than half of all first-time purchasers used the FHA program when buying a house. This is primarily due to the lower down-payment requirements and easier qualification criteria associated with these loans.

But FHA mortgages may be harder to come by in 2013, as the result of some new rules for credit scores and debt ratios. Here’s what you need to know:

Current Rules for FHA-Insured Mortgage Loans

The FHA does not lend money to home buyers. Rather, they insure the loans made by lenders in the private sector. The money comes from the bank, as with any other type of mortgage. Thus, they are government-backed mortgage loans. While the FHA manages the program, the lender has the final say on whether or not a borrower is qualified.

FHA overview

Credit scores are one of the most important criteria for FHA loans, and mortgages in general. Consumer credit scores are like a report card of past borrowing activity. These three-digit numbers are derived from information found within a consumer’s credit report. The reports contain a detailed history of current and past credit card accounts, personal loans, payment histories, delinquencies, and other financial activities.

A low score makes it harder to qualify for a home loan, while a higher score makes it easier to get approved.

There are two official credit-score cutoffs for FHA loans. They are 500 and 580. Borrowers need a 500 or higher just to be eligible for the program.* Additionally, borrowers need a 580 or higher to qualify for the 3.5% down-payment option, which is the biggest benefit of the FHA program.

* The official cutoff for program eligibility is 500. But it’s unlikely a borrower would actually qualify for a loan at that level. Most lenders today require scores of 600 or above for FHA financing. These are known as ‘overlays.’

Officials with the Department of Housing and Urban Development (HUD), which oversees the FHA program, recently announced some additional changes to these program guidelines.

Extra Scrutiny for Borrowers in the 580 – 620 Zone

The FHA is struggling to survive. Mounting financial losses have wiped out the agency’s financial reserves. A congressional mandate requires the agency to maintain capital reserves equal to 2% of its total loan guarantees, or above. It dipped below that level three years ago, when the foreclosure crisis came to a head. Last year, the agency’s reserves stood at 0.2% of all loan guarantees. According to the latest report, they have now fallen to -1.4%.

HUD is trying to staunch the bleeding. Over the last couple of years, they have implemented a number of program changes designed to slow the FHA’s losses (in the short term) and rebuild its capital reserves (over the long term). The latest change has to do with credit scores and debt-to-income ratios. It will take effect in 2013.

Republican Sen. Bob Corker of Tennessee is one of many in Congress who are pressing for changes to the FHA program. In exchange for such reform, Corker said he will support Carol Galante’s confirmation as the next commissioner of the Federal Housing Administration. (Galante stepped in as acting commissioner in 2011, when David H. Stevens left to join the Mortgage Bankers Association.)

Here is an excerpt from a letter sent from Carol Galante to Bob Corker on December 18, 2012:

“FHA … will require borrowers with scores below 620 to have a maximum debt-to-income ratio no greater than 43 percent in order for their loan applications to be approved through FHA’s TOTAL Scorecard … If a borrower’s DTI exceeds 43 percent, lenders will be required to manually underwrite the loan.”

The TOTAL Scorecard is an automated system that helps lenders determine if a borrower is qualified for the government-backed mortgage program. In other words, it’s part of their automated underwriting system. Going forward, borrowers with credit scores below 620 will receive additional human scrutiny during the underwriting process. The underwriter must find — and document — some kind of compensating factor, such as a large down payment, in order to approve the borrower.

In plain English: Borrowers with credit scores below 620 will set off a red flag in the FHA’s computerized screening program. At that point, a mortgage underwriter must step in to make sure they don’t have too much debt. If the borrower’s combined debts use up more than 43% of his or her monthly income, the loan may fall through. However, if the underwriter finds some positive factors to offset the higher debt ratio, the loan may still go through.

Note: This is a preliminary report on a developing story. We expect to learn more about the new FHA credit-score requirements over the coming weeks. This story may be updated in 2013, as additional details emerge.

Why the FHA Program is So Popular Among First-Time Buyers

The FHA loan program has been helping home buyers since the 1930s. Through this program, borrowers are able to purchase a home with a government-insured mortgage loan. This insurance protects the lender from losses stemming from borrower default.

The FHA program is especially popular among first-time home buyers. A 2012 survey by Campbell Communications and Inside Mortgage Finance found that 53% of first-time buyers used FHA loans when buying a home. This is not surprising, as the program offers several key benefits to this particular group.

We will talk about those benefits in a moment. But first, some definitions are in order:

An FHA loan is a mortgage that is insured by the government, through the Federal Housing Administration (part of HUD). Financing is provided by a lender in the private sector — not by the government. The federal government insures the lender against losses, in the event that the borrower fails to make payments.

How FHA Loans Work

As a result of this government backing, mortgage lenders are willing to relax certain guidelines during the approval process. The FHA program is often the last resort for borrowers with limited capital, low credit scores, or other qualification problems.

Check out our 2013 FHA outlook.

The Benefits of Using an FHA Loan

What makes this program so popular among first-time home buyers? It’s a combination of factors, really. Here are the top benefits for borrowers:

1. Low down payments. FHA allows borrowers to make down payments as low as 3.5% of the amount borrowed. Conventional loans, on the other hand, require down payments of 5% or higher. Some lenders require a minimum of 10% on conventional loans, especially when the borrower has shaky qualifications (bad credit, high debt ratios, etc.).

2. Lower credit-score cutoff. The Department of Housing and Urban Development (HUD) has imposed a minimum credit score of 500 for all FHA loans. Granted, lenders have the final say, and most of them require scores well above 500. But overall, the cutoff is typically lower for government-backed mortgages than conventional financing. Lenders allow scores down to 600, and sometimes below, for the FHA program. The minimum score for conventional financing is typically 20 – 40 points higher.

3. Flexible debt ratios. Debt can be a deal-breaker during the mortgage approval process. If a borrower carries too much debt relative to monthly income, he or she may be denied financing. In lending jargon, this is known as the debt-to-income ratio, or DTI. Government-backed mortgages typically have lower DTI restrictions, when compared to conventional loans. Most lenders today limit total monthly debt to 39% – 41% of income, for conventional loans. But there’s more leniency in the FHA program. We have seen borrowers with excellent credit get approved for FHA with debt ratios as high as 50% (whether it’s wise to do so is the subject of another article).

[Update: Borrowers with credit scores below 620 could face higher DTI standards in 2013. Learn more]

4. Streamlined refinancing. Borrowers with an FHA loan can refinance into a new government-backed mortgage with minimal hassle, and sometimes without an appraisal. This can be a huge benefit in certain scenarios. For instance, if rates drop significantly a few years after the original home purchase, eligible homeowners could use the FHA streamline refinance program to secure a lower rate. This could lead to big savings over time.

5. Down payment gifts. With an FHA loan, the entire down payment can be gifted from a family member — ‘entire’ being the key word. In contrast, most conventional loans do not allow 100% gifting for the down payment funds. This is another key benefit of the FHA program, one that appeals to first-time home buyers in particular. The borrower must obtain a letter from the family member who gifted the money. At a minimum, the gift letter must include (A) the dollar amount given; (B) the name, address and phone number of the donor; and (C) a statement that no repayment is required.

6. FHA loans are assumable. Most conventional mortgages are not. ‘Assumable’ means that if the homeowner decides to sell the home, he or she can transfer the mortgage to the new buyer. Many buyers will see this is a major benefit, especially if the homeowner’s interest rate is lower than current interest rates.

According to Jack Guttentag, the Mortgage Professor, “having the buyer assume the seller’s loan can be better for both. The buyer enjoys a [potentially] lower rate and avoids the settlement costs on a new mortgage.”

FHA Loan Outlook for 2013: Low Rates, Higher Fees, Rising Popularity

The FHA loan program has grown in popularity since the housing crisis began in 2008. It has become the financing tool of choice for many home buyers, especially those with limited down payments or shaky credit.

This trend will likely continue in 2013. In fact, new mortgage-lending rules could steer even more borrowers toward the FHA program in 2013. Here’s a rundown of recent developments.

Growth in FHA Market Share, 2008 – Present

The housing crisis came to a head in 2008. That’s also when the FHA’s market share skyrocketed. This is no coincidence.

During the housing boom of the early 2000s, it was fairly easy to qualify for a mortgage loan. You didn’t even have to document your income. You could opt for a ‘stated income’ loan, and simply tell the lender how much you made. Payments too big? Just defer the principal and pay only the interest. No credit? No problem. Try one of our subprime mortgage options. It was the real estate equivalent of a used car clearance sale.

Things have changed. Today, those same lenders will require a mountain of paperwork to verify your income, debts and assets. No more winks and handshakes. You have to provide evidence. Lenders are also requiring higher credit scores and lower debt levels than before the crisis. These tougher requirements have sent an increasing number of borrowers to the FHA loan program.

The chart below says it all. During the housing boom, on the left side of the chart, FHA’s share of the mortgage market fell below 5%. It was easier to qualify for a conventional loan back then. So fewer people had to resort to government-backed mortgages. When the bubble burst, FHA’s market share shot up to nearly 40% (represented by the green bars in the chart). So there is a direct correlation between conventional lending standards and the popularity of FHA loans.

The Department of Housing and Urban Development (HUD), which manages the program, summed it up this way: “In recent years, FHA has experienced significant swings in its market share as it has stepped in to provide capital for qualified borrowers who would otherwise be shut out of the borrowers mortgage market.”

This program is especially popular among low-income borrowers and minorities. According to HUD data, 60% of Latino and African American home buyers used FHA loans to buy a home in the last year.

Mortgage Insurance Will Cost More in 2013

While the popularity of FHA has risen, so too have the costs. Borrowers who use these loans must pay a mortgage insurance premium. In fact, there are two premiums. There’s an annual mortgage insurance premium (MIP), as well as an upfront premium. Despite their names, both can be rolled into the loan and spread over monthly payments.

HUD raised the annual MIP for FHA loans in April 2011, in response to capital reserve shortfalls. They recently announced they will raise it again. So any borrower who uses an FHA loan to buy a house in 2013 will face higher premiums, averaging an extra $13 per month.

They are charging the higher fees to avoid the necessity of a taxpayer bailout, which they haven’t ruled out. HUD Secretary Shaun Donovan believes the recent changes “have significantly decreased the chance of having a bailout at the end of 2013.”

Congress is pressing for serious reform at the FHA, so we can probably expect additional changes in the coming months.

Low Rates Expected to Continue in 2013

While FHA mortgage premiums may be rising, interest rates are expected to remain low. Some recent predictions from industry insiders suggest that 30-year rates on home loans could stay below 4% throughout 2013. Rates for conventional and government-backed loans generally track closely, so that prediction applies to the FHA program as well.

The Mortgage Bankers Association has also predicted that rates will remain below 4% next year, partly due to the Federal Reserve’s ‘quantitative easing’ policy. Fed Chairman Ben Bernanke said that the latest round of easing should “put downward pressure on mortgage rates and create more demand for homes and more refinancing.”

The interest rate assigned to a loan is partly influenced by the borrower’s qualifications. This may come as a surprise to some first-time buyers. For instance, we publish a weekly average of FHA rates being offered by lenders. But not all borrowers will qualify for the average. Some will qualify for a lower rate, and some will be assigned a higher one. Mortgage lending is a highly individualized process. Borrowers with excellent credit and minimal debt typically qualify for lower rates — and vice versa.

The bottom line: Well-qualified borrowers may find FHA mortgage rates below 4%, for at least the first half of 2013.

New Lending Rules on the Horizon

A new set of lending rules is scheduled to take effect next year. Collectively, they are known as the qualified mortgage, or QM. They are an offshoot of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

In short, QM creates a set of standardized rules and qualifications for home loans. Lenders who adhere to these rules when generating loans will be offered some degree of legal protection against consumer lawsuits. So the new rules could set the bar in terms of lending standards.

You can learn more in our qualified mortgage fact sheet.

We won’t know exactly what those rules look like until the January 2013 deadline for finalization. But if they turn out to be stricter than expected, a higher number of borrowers could resort to using FHA loans when buying a house.

In summary, we expect FHA’s share of home purchase loans to remain consistent next year, despite the increase in mortgage insurance premiums. If the new lending rules make conventional loans harder to come by, FHA’s market share could once more approach — or even exceed — the 40% level. Interest rates on 30-year fixed mortgages will likely remain below 4% in 2013, though much depends on the borrower’s qualifications.

Will QM Rule Steer Borrowers Toward FHA Loans in 2013?

Some new mortgage-lending rules are scheduled to take effect next year, and they could steer even more borrowers into the already popular FHA loan program. It all depends on how those rules are defined.

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law. This legislation seeks to curb many of the risky financial practices that contributed to the U.S. recession of the late 2000s.

Coming in 2013: The Qualified Mortgage

On the mortgage-lending front, it calls for the creation of a qualified mortgage (QM), a set of rules intended to produce safer home loans. It also calls for a separate, but similarly named, requirement known as the qualified residential mortgage (QRM). Both rules are scheduled to take effect in January 2013, or shortly thereafter.

As shown below, the borrower’s ability to repay is a central theme of the QM guidelines.

QM and QRM at a glance

To learn more about the forthcoming QM rules, please refer to our qualified mortgage fact sheet.

How Will QM Affect Lending Standards in the U.S.?

A 2011 study conducted by the U.S. Government Accounting Office (GAO) found that the QM-related provisions of the Dodd-Frank Act may have minimal impact on the mortgage market. They examined some of the QM criteria outlined in the Dodd-Frank Act, and compared them to mortgage loans generated between 2001 and 2010. Their determination: “Most mortgages would likely have met the individual criteria.”

In other words, the forthcoming rules might not change much.

QM is designed to prevent a return to the days of exotic, high-risk mortgage loans. But most of the ‘creative financing’ options used during the housing boom have already fallen by the wayside. Lenders have gotten away from using them. Stated-income loans and interest-only mortgage payments are two good examples. These features were all the rage during the housing boom. But when the bubble burst, lenders began to avoid them. These are the types of high-risk features Dodd-Frank seeks to eliminate, by implementing the qualified mortgage standards.

On the other hand, the GAO study does point out that QM could limit mortgage options for some borrowers. Here is a quote from their report to Congress:

“…some consumer and industry groups stated that some of the QM criteria could increase the cost and restrict the availability of mortgages for some borrower groups, including lower-income and minority borrowers.”

Much depends on the final version of these rules. The Consumer Financial Protection Bureau (CFPB) has evaluated feedback from the consumer and industry groups mentioned above. They are now on track to finalize the qualified mortgage rules by January 2013, barring any procedural delays. It should be an interesting year, as far as home loans go.

More Borrowers Lining Up for FHA Loans?

An FHA loan is a residential mortgage loan that is insured by the U.S. government, under the management of the Department of Housing and Urban Development (HUD). This type of financing is popular among first-time home buyers, in particular, because it allows for a down payment of only 3.5%. But it’s not limited to first-time buyers. Anyone who meets the program guidelines can qualify for this type of financing.

FHA loans also have less strict qualification criteria, when compared to regular conventional mortgages. This appeals to borrowers with low credit scores or other qualification problems.

The popularity of the FHA program spiked in the wake of the housing crisis. As lenders tightened their standards to prevent further losses, many marginally qualified borrowers had nowhere else to turn. As a result, the FHA’s market share rose from around 5% to nearly 40% in just a few years (see chart below).

Today, it is still one of the most popular financing options for first-time home buyers, and those with credit problems. The low down-payment requirement, combined with less rigid criteria, makes FHA the first choice for many borrowers.

Will even more borrowers flock to the program in 2013, as the QM rules take effect? It’s a likely scenario. But again, it all hangs on the final definition of the qualified mortgage.

For instance, we know by reading through the Dodd-Frank Act that debt-t0-income (DTI) ratios will come into the picture. But we don’t yet know the limits for these ratios. Dodd-Frank simply states that a QM loan must comply with “any guidelines or regulations established by the Board relating to ratios of total monthly debt to monthly income … taking into account the income levels of the borrower.”

If they impose stricter guidelines for DTI ratios than we’ve seen in 2012, they could inadvertently drive more borrowers toward FHA loans in 2013. It’s worth watching, at the very least.

Mortgage Rates Hovering at Record Lows

In other lending news, mortgage rates in the 30-year and 15-year categories inched upward a bit yesterday. But they are still hovering at record lows. On November 29, 2012, Freddie Mac reported that the average rate for a 30-year fixed mortgage rose from 3.31% to 3.32%. That makes this week’s average the second lowest in four decades of tracking.

Rates are expected to remain low for the rest of this year and into 2013, minor fluctuations aside. This, combined with the prospect of stable and rising home prices, may bring more buyers into the market in 2013.

According to Frank Nothaft, chief economist and vice president at Freddie Mac: “even if we see some upward pressure on fixed-rate mortgages in 2013, they are still likely to remain extraordinarily low.”

Current State of FHA Financing, and a 2013 Sneak Peek

The FHA financing program has been around since 1934, when it was born from the Great Depression. It was created to broaden the home-buyer pool, specifically by making mortgage loans available to people who wouldn’t otherwise qualify for a loan. Today, it is the mortgage program of choice for many home buyers. Recent and forthcoming changes in the lending industry could increase the FHA’s market share even more.

When the housing crisis began in 2008, more and more home buyers had to rely on government-backed financing. As a result, the FHA’s market share rose significantly. The chart below presents this trend clearly enough. At one point, FHA financing accounted for nearly 40% of all mortgage activity. For many borrowers, these loans were the only viable option.

FHA’s share of the mortgage market, 2003 – 2012

This chart shows the percentage of total mortgage loans that were made through the FHA financing program. Stated differently, it shows the agency’s share of the mortgage market, when measured by loan origination. The green bars represent purchase loans (home buyers), and the blue bars represent refinance loans (homeowners).

As you can see, FHA financing accounted for less than 10% of the market for the first half of the decade. The spike you see starting in 2008 coincides with the collapse of the U.S. housing market, which started that same year. On the purchase side, FHA market share peaked at nearly 40% toward the end of 2009. It has hovered at about 30% for the first few months of 2012.

There’s a good chance the agency’s market share will rise again in 2013, when new mortgage regulations are introduced. We will talk about those new regulations in a moment. But first, a bit of background information:

Quick Primer: What is FHA Financing?

What is FHA financing, and how does it work? Where does the money come from? Here’s a quick primer on the government-insured mortgage program.

Mortgage lending is a risky business. When a financial institution makes loans to borrowers, it takes on a certain amount of risk. The primary risk comes in the form of default. As long as the lender retains and services the loan, there is a risk that the borrower will someday be unable to make the payments.

To minimize these risks, lenders (and the institutions that purchase their loans) establish certain criteria for borrowers. These criteria include such things as credit scores, income verification, debt ratios and more. Borrowers who fall short in these areas may not be able to qualify for a home loan.

The same is true for other types of financing as well, such as personal and auto loans. Lenders protect their interests and reduce their risks by ensuring borrowers meet minimum standards of qualification. This means some people simply won’t qualify for financing. Such is the case with home loans. In fact, in the current mortgage environment, there are more denials of credit than there are approvals.

That is where the FHA financing program comes into the picture. Since 1934, the federal government has been insuring mortgages against borrower default. This reduces risks for lenders and increases the chance of approval for borrowers. The graphic below explains how FHA financing works, in a general sense.

Overview of FHA Financing

Key takeaways from this graphic: (1) The purchase money comes from a regular lender, not from the government. (2) The government’s insurance is designed to protect the lender’s interests, not the borrower’s. (3) It is generally easier to qualify for an FHA loan, as compared to conventional mortgage financing.

An Uncertain Future?

FHA financing currently accounts for about a third of all mortgage activity in the U.S. We expect this trend to continue through 2012. But there is also some uncertainty around the future of the agency, and the level of its involvement in the mortgage market.

The Department of Housing and Urban Development (HUD), which oversees this program, is currently struggling with financial losses resulting from defaulted loans. These are home loans that were insured through the FHA financing program and later went bad as the homeowners stopped making their payments.

By current estimates, the government agency has more than 700,000 of these bad loans, representing 9% of all loans in its portfolio (source: Reuters). These loans put a serious financial drag on the program. Desperate for solutions, HUD has developed some creative strategies for reducing the number of bad loans.

There is also much uncertainty surrounding the qualified mortgage (QM) and the qualified residential mortgage (QRM). These new regulations are expected in early 2013, and they could raise the bar in terms of mortgage-qualification procedures. I wrote about these forthcoming rules last week, if you’re interested. Here they are at a glance:

Diagram: QM and QRM Regulations

As you can see from this diagram, the QRM rules are an offshoot of the risk-retention requirements built into the Dodd-Frank Act. Risk retention forces lenders to retain at least 5% of the home loans they securitize and sell. But FHA loans will be exempt from these retention rules (under the current proposal, at least).

The new QRM rules could result in higher interest costs and stiffer lending criteria for conventional home loans. But the new rules should have less impact on government-insured loans, since they are exempt from those rules. This could steer even more buyers toward the FHA financing program in 2012, and could result in another rise of the agency’s market share. Time will tell.