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.

FHA Loan Update: Debt Collection Over $1,000 Could Kill the Deal

Update — The proposed rule regarding debt collections on FHA loans was rescinded by the Federal Housing Administration in June 2012. So it will not take effect. We have left the original article intact, below, as a historical reference.

Reader question: “I have heard there is a new rule for FHA loans, where a collection item on your credit report could prevent you from qualifying for a loan. It this true? And if so, does it apply to all debt collections regardless of the date and amount? I just realized I have one of these negative entries on my TransUnion report, and possibly all three. I’m worried it could cause problems when we apply for an FHA home loan later this summer.”

You have heard correctly. There have been some adjustments to the FHA program recently. It’s actually a revision to an existing rule. The older rule was somewhat vague and left things up to the lender’s discretion. The new rule is more specific, so it could cause problems for some borrowers who have negative entries on their credit reports. Here’s what we know at this point:

New FHA Rules for Debt Collections and Disputed Accounts

The Department of Housing and Urban Development has made some changes to the FHA loan program. These changes took effect on April 1, 2012, so they apply to all FHA-insured home loans going forward. In short, if you have some type of disputed account on your credit report (such as a debt collection) with a balance of $1,000 or more, you may no longer qualify for an FHA loan.

FHA rule for debt collections

This is a major change to HUD’s previous policy on the matter. In the past, mortgage lenders had the authority to review, and possibly approve, borrowers with unpaid collection items on a case-by-case basis. The revised rule takes some of that authority away from the lenders. Going forward, borrowers with disputed accounts of $1,000 or more in their credit reports will have to take some form of corrective action, before they can be approved for an FHA loan. These borrowers would have to pay off the outstanding debt, or provide evidence that the debt is erroneous (as in cases of identify theft). Either of these actions would satisfy the corrective requirements.

Read more: A review of FHA loan guidelines for 2012

According to HUD officials, these changes have been implemented to reduce the number of defaults on FHA home loans. A default occurs when a borrower stops making payments on a loan, for whatever reason. The idea is that, by clarifying and tightening certain aspects of the FHA qualification process, the federal government can reduce the total number of defaults on these loans going forward. In turn, this would reduce the amount of money HUD has to pay for lender insurance claims.

Whether or not this change will have the desired effect remains to be seen. We won’t know until at least a year’s worth of data have been collected. So the new rule is probably here to stay, at least into 2013.

Some lenders fear the new FHA rule on credit reports will disqualify borrowers who are otherwise excellent candidates for a loan. For instance, a borrower with solid income and a high credit score could still be disqualified for an FHA loan, due to an unpaid bill from two years ago.

Only time will tell how many borrowers are affected by the revised rule. Some lenders are more concerned than others. Clem Ziroli Jr., president of First Mortgage in Covina, California, believes that some 35% of borrowers who qualified for FHA loans in the past would be ineligible under the new guidelines. (Tip of the hat to real estate columnist Kenneth Harney for his interview with Mr. Ziroli.)

Collections Can Stay On a Credit Report Up to Seven Years

The debt-collection industry is heavily regulated by the federal government, through the FTC. The same goes for the credit reporting bureaus. Thus, there are specific rules as to how long something can stay on your credit report. All of these rules can be found within the Fair Credit Reporting Act (FCRA), a federal law that was originally passed in 1970.

According to the FCRA, most negative entries can stay on a person’s report for up to seven years. This rule applies to late payments and debt collections, as well as any accounts that have been ‘written off’ as a loss by the original creditor. Bankruptcies can stay longer, for up to ten years.

Borrowers who are planning to apply for an FHA loan should check their credit reports for accuracy, and also to identify any disputed accounts that may pose a problem. You can obtain your reports once a year for free, from all three of the reporting companies: TransUnion, Equifax and Experian. The best way to do this is by visiting AnnualCreditReport.com. This website is jointly owned by the three bureaus and regulated by the federal government. (This website should not be confused with the countless websites that offer ‘free’ reports as an enticement to buy credit-monitoring services.)

Magic Numbers: Two Years and $1,000

The question is, will a disputed account from five or six years ago wreck your chances of getting an FHA loan? That will depend on the circumstances and recent actions surrounding the debt. If the item has been completely inactive for more than two years, and is less than $1,000, it might not be a problem. But if some kind of action has been taken within the last couple of years (like a partial payment toward the account), it becomes an issue.

According to the HUD letter that explains this change, borrowers could be exempt from the rule if they meet both of the following conditions:

  • The total outstanding balance of all disputed accounts on the credit report add up to less than $1,000.
  • The disputed items are “aged two years from date of last activity as indicated on the most recent credit report.”

If you have a collection item on your credit report, but it meets both of the criteria above, it might not prevent you from getting an FHA loan. The only way to find out for sure is to apply for a loan through an FHA-approved lender. They will review your file to determine where you stand, in relation to these new rules.

Collection Corrections: The Required Course of Action

Under the new guidelines, borrowers with disputed accounts (including collections) totaling $1,000 or more will not qualify for an FHA loan. These borrowers have several courses of action. They can pay the disputed debt at or before closing. If the debt appears on the borrower’s credit report in error, he or she can provide evidence to have the requirement waived. For example, in cases of identify theft, the borrower could file a police report or a make an official complaint with the credit-reporting bureaus to dispute the erroneous entry.

When gathering paperwork for the loan, the mortgage lender must include documentation that shows “all disputed or collection accounts are resolved, verified as not a debt to the borrower, arrangements made for payment, or paid in full.” (Source: HUD Mortgagee Letter 2012-3)

FHA Criteria for 2012 – Borrowers Can Expect More of the Same

Editor’s note: This page has been updated for 2014. Read the updated version here.

What does it take to qualify for an FHA loan in 2012? This is a hot topic among home buyers lately. It’s also one of the most common questions we receive from our readers. We surveyed more than two-dozen lenders on this subject. This is what they had to say.

FHA Loan Guidelines

Based on recent emails we have received, there seems to be a lot of confusion regarding current FHA criteria. Many home buyers have expressed concerns about the imminent demise of the program. Others have heard rumors that a mandatory 10% down-payment requirement is coming down the pike. Both of these are false. In an effort to prevent any additional rumors from surfacing, we have compiled a list of FHA loan criteria.

Definition: An FHA loan is a government-backed mortgage. It is insured by the Federal Housing Administration, which is part of the Department of Housing and Urban Development (HUD). These loans are offered by government-approved lenders within the primary mortgage market. In the event of default, the lender will be insured against losses. This program has broad appeal among home buyers, mainly due to the lower down-payment requirement and easier qualification process.

A Survey of 27 Lenders

We keep in touch with a group of mortgage lenders across the United States. We frequently query them about current lending trends, market news, and other topics that might interest our readers. For this story, we contacted all of the lenders that are government-approved to make FHA loans. We also solicited input from some of the largest banks in the country, including Wells Fargo. In all, we received input from more than 27 lenders for this story. Here is what they told us about FHA criteria in 2012.

The FHA’s Cash-Reserve Problems

The FHA is required by Congress to maintain cash reserves equal to 2% of the loans they insure. Historically, they never had a problem meeting this requirement. But the organization’s reserve fund plummeted during the housing crisis, largely due to insurance claims resulting from homeowners defaulting on their loans. In November of 2011, an independent audit found that the reserve fund had fallen to 0.24%. This comes at a time when the Obama administration is looking for ways to scale-down the government’s role in the housing market.

The FHA’s future is uncertain. There is talk of a taxpayer bailout over the new few years, to bolster the organizations depleted reserves (the money it uses to insure home loans). According to Joseph Gyourko, a real estate professor at The Wharton School: “It’s highly likely that the FHA will need a taxpayer bailout over the next three to five years.”

The lenders we spoke to had mixed views on this subject. Some expressed concerns that the FHA was “on its way out.” Others felt that the government would keep the program going for at least a few more years, if not longer. But most agreed that the situation would not affect FHA borrower criteria in 2012. “Whatever happens down the road, it’s pretty much a non-issue for the rest of 2012,” said one broker.

Minimum Borrower Criteria for 2012

There’s an abundance of misinformation online today, with regard to FHA loan guidelines. You’ll find conflicting information about down payments, credit scores, debt ratios, and every other aspect of the lending process. This leaves home buyers scratching their heads (and sending us a steady stream of emails). Here’s what you need to know about FHA guidelines in 2012:

1. Down Payment Guidelines

When using an FHA mortgage loan to buy a house, you will have to make a down payment of at least 3.5%. There is a lot of Internet “chatter” right now about HUD’s plans to raise the minimum down payment to 5%, in order to replenish its reserve fund. But so far, this is only speculation. There have been no official announcements on this subject. And even if they do decide to make such a change, it probably would not take effect in 2012.

Nearly all of the lenders we spoke to felt confident the 3.5% down-payment requirement would stay in effect for the rest of this year.

If your credit score falls below 580, you might have to make a down payment of 10%. HUD’s official policy states that “borrowers with less than a 580 FICO score will be required to put down at least 10%.” But, as you will soon see, this requirement is something of a moot point. Mortgage lenders impose their own (often stricter) requirements on top of the minimum guidelines established by the FHA.

[Related story: Why you don’t need a 20% down payment]

2. Credit Score Guidelines

Of all the criteria mentioned in this article, the down-payment requirement is the one that is most firmly set in stone. Credit scores are a different story. Here, much depends on the particular lender you use.

Some of the lenders we spoke to set the bar at a 620 FICO credit score, for all of their mortgage products. Some had a lower minimum for FHA loans, as compared to conventional loans. Others were willing to go as low as 580, as long as the borrower has stable employment and income. Quicken Loans, for example, says that borrowers “may now qualify for an FHA loan with a credit score of 580 and above.” So the standard will vary based on the lender you use.

We also spoke to a representative from Wells Fargo (the nation’s largest mortgage lender). In 2011, the New York Times reported that Wells Fargo was offering FHA loans to borrowers with scores as low as 500. This would have marked a significant divergence from the 600-and-up crowd. So we asked them about this. Here is what a representative told us:

Wells Fargo Quote
Other large lenders had similar standards. Chad Baker, a loan officer with Prime Lending, told us that his company “will provide FHA financing down to a credit score of 600,” adding that “there are mortgage banks that are providing FHA financing below a FICO score of 600.” So a score of 600 or higher was the closest we could come to a general consensus. But again, it all depends on (A) which bank you use and (B) how well you measure up in other areas.

3. Debt-to-Income Guidelines

There seems to be a lot of leeway, with regard to the maximum allowable debt ratio. We will get to that in a moment. But first, a quick definition is in order.

The debt-to-income (DTI) ratio shows how much of your monthly income is going toward your debts. For example, a DTI of 30% would suggest that you are using 30% of your income to pay your debts. As far as FHA criteria are concerned, there are two DTI ratios. The front-end ratio only includes your housing-related debts, such as your mortgage payment. The back-end ratio combines your housing debt with all of your other debts — credit cards, car loans, etc.

Lenders tell us that the combined number (the so-called back ratio) is most important, when it comes to being approved for an FHA loan. This is the one that takes into account your housing costs as well as your other debts. Some said 43% was the maximum allowable back-end ratio. Others said they’ve seen borrowers get approved through automated underwriting systems with combined DTI ratios close to 50 percent.

My advice is for borrowers to keep their back-end ratios below 43%. If you do that, you shouldn’t have any trouble qualifying for an FHA loan (as long as you meet all of the other guidelines mentioned above).

New: The Weekly Composite of Mortgage Rates

We recently launched a new feature of the website that’s relevant to this story. It’s a weekly composite of FHA mortgage rates. It shows the current rates being offered by lenders across the country.

We obtain this information through a survey of 25 FHA-approved lenders located throughout the United States (including some of the larger national banks). The composite is updated every Thursday at noon (CST). This is just one of several new features we will be rolling out in 2012.

600: Magic Number for Credit Scores on FHA Loans in 2012

The FHA home loan has long been considered the side door to homeownership, for borrowers who don’t qualify for a conventional mortgage. This is true, to a certain extent. It’s typically easier to qualify for an FHA loan, because the federal government insures the lender against losses resulting from default. This insurance encourages lenders to give loans to borrowers with weaker qualifications, such as those with below-average credit scores.

But if you think you can qualify for this program with just any credit score — think again. Based on our conversations with mortgage lenders, it seems that 600 is the magic number for credit scores on FHA loans. That was the minimum requirement mentioned by most of the lenders we spoke to (and some had even higher standards). These standards will likely continue throughout 2012, as well.

Scores Allowed by FHA are Often Unacceptable to Lenders

There is a lot of confusion surrounding FHA loans and credit scores. Most of this confusion stems from the two-tiered system of approval. When you apply for an FHA loan, you essentially have to meet two sets of standards — the government’s and the lender’s.

The governmental standards are established by the Department of Housing and Urban Development (HUD), which oversees the Federal Housing Administration. Mortgage lenders establish their own guidelines, usually in conjunction with the conforming loan standards set by Feddie Mac and Fannie Mae.

Let’s start with the governmental requirements for credit scores on FHA loans. A HUD news release from November 2011 stated the following: “Specifically, a minimum down payment of 10 percent is now required of borrowers with credit scores below 580, and applicants with credit scores below 500 are no longer eligible for FHA insurance.”

This suggests that borrowers with credit scores between 500 and 579 could still qualify for an FHA loan, but they would have to make a larger down payment. So the government has established two cutoff points for scores. The first cutoff (500) relates to basic qualification for the program. The second cutoff (580) relates to the down-payment requirement. But in many cases, both of these numbers become moot. Most of the lenders we spoke to said they will require credit scores of 600 or higher for FHA loans in 2012.

The government says you can qualify for the program with a score as low as 500, as long as you meet all of the other guidelines. But you may have a hard time getting approved by a lender with a score that low. In the lending industry, this is referred to as an overlay.

600 is the Magic Number These Days

In 2012, borrowers will likely need a credit score of 600 or higher to be approved for an FHA loan. Just keep in mind there are exceptions to every rule. Some lenders will make an exception for borrowers with large down payments, low debt levels, etc.

In order to get a broad sampling, we queried a number of FHA-approved lenders at the national, state and local level. Most of them said they would work with borrowers who had a score of 600 or above.

For example, here’s what Chad Baker, a loan officer with Prime Lending, had to say about it:

“FHA is back in full force and has positioned itself as the new ‘sub-prime mortgage.’ PrimeLending will provide FHA financing down to a credit score of 600. There are mortgage banks that are providing FHA financing below a FICO score of 600.”

In February of 2011, the New York Times stated that Wells Fargo had lowered its credit-score minimum on FHA loans from 600 to 500. This would have been significant news, given (A) the size of the reduction and (B) the fact that Wells Fargo is the largest mortgage lender in the United States. So I asked them about this policy change.

My question to them: Could a borrower with a credit score of 500 or above (who meets all other guidelines) still be approved for an FHA loan through Wells Fargo? This is what a Wells Fargo spokesperson told me:

“Through our direct-to-consumer channel (Retail), we currently offer FHA loans to customers with credit scores as low as 600. We also have an exception process to allow for applications from otherwise qualified borrowers who have credit scores below 600. This reverses an action taken to lower the credit score on purchase loans through our retail channel that was effective Jan. 15, 2011. Since then, we have learned that too many customers were confused by the program requirements or had recent issues with credit that prevented them from qualifying.” -Source: Wells Fargo spokesperson, November 30, 2011

So we have a situation where HUD says they’ll allow scores as low as 500 for FHA loans, but most lenders won’t go below 600. As far as the borrower is concerned, the lender has the final say in all of this. It doesn’t really matter what HUD says. The lenders establish their own system of risk-based analysis. And that’s exactly what a credit score is — it’s a measurement of risk. Statistically speaking, it tells the lender how likely you are to repay your debt.

[Related: A simplified guide to credit scores]

Over the last 90 days, the average credit score among borrowers who used FHA loans was around 695 – 705. At the height of the housing boom, the average score for borrowers in this category was significantly lower. This reflects the higher standards lenders have for FHA loans in the current lending environment.

About the FHA Loan Program

The FHA mortgage loan program was created in 1934, as part of the National Housing Act. It is managed by the Department of Housing and Urban Development (HUD). The program’s goal is to make homeownership accessible to more Americans. It does this by insuring loans made by mortgage lenders in the private sector. Government insurance is the key to the program. If the borrower defaults on the loan, the lender gets covered for any losses. Thus, lenders are willing to relax their standards for approval. Credit scores are one of those standards.

HUD: No Immediate Plans to Raise FHA Down Payments

Rumors are circulating that the Department of Housing and Urban Development plans to increase the down-payment requirement for FHA loans. The move would increase the minimum down payment from 3.5% to 5% of the purchase price. Actually, it’s an old rumor that has been rejuvenated. People were speculating on this at the end of 2009 as well.

Fact: According to HUD, there are currently no plans on the table to raise the FHA down payment to 5%. Currently is the key word there.

Here’s how these rumors usually get started. Someone from the mortgage industry will say something like: “The way things are going now, I wouldn’t be surprised if the FHA raised their minimum down payment to 5% in the near future.” While it’s true the FHA has made some changes to boost its capital reserves, higher down payments are not one of them. Not yet, anyway.

Sometimes the idea will actually come from a reliable source. That may be the case this time around. There have been reports that the Obama administration is proposing a down-payment increase to Congress (FHA changes require congressional review).

Regardless of the source, it doesn’t take long for the Internet rumor mill to spin it. It’s the real estate equivalent of the whisper game played by kindergartners. I recently encountered a real estate agent’s blog that warned home buyers to “act quickly” because FHA down payments are “rising as we speak.” Some agents will say anything to give shock therapy to a sluggish market.

FHA Fact vs. Fiction

HUD spokesman Lemar Wooley recently said the housing agency has no plans to increase the down payment requirement on FHA home loans. And this is hardly a secretive group we’re talking about. They’re a government agency, and all major policy changes have to go through Congress. So a higher down payment would require a vote in both the House and Senate. It would need to be proposed and outlined long before it would actually take effect. These things don’t happen under the radar. And the fact that people have been kicking this idea around since 2009 should be taken into account.

But then there’s this from the Washington Post:

Borrowers looking to take out FHA loans — the mortgage of choice in recent years for cash-strapped borrowers — could see the minimum down payment requirements rise from 3.5 percent, the administration said in a report to Congress last month.

When it comes to the FHA’s policies, changes can come from different directions. They can be proposed by officials within the Federal Housing Administration, and then reviewed / approved by Congress. Or they can be proposed by the president and his advisors, and sent to Congress for consideration. So it’s possible that, while Lemar Wooley is speaking the truth about having no plans to raise down payments, those plans are being made “above his pay grade.”

Frankly, I wouldn’t be surprised to see higher down payments for FHA loans in the near future. It would fall in line with the Obama administration’s goal of reducing the government’s role in housing. This includes plans to phase out Fannie Mae and Freddie Mac over the next few years. There has even been talk of making a 10% down payment the new norm for conventional mortgage loans (those that are not insured by the government). But even this proposal is facing a lot of push-back from consumer groups and smaller lenders.

Credit Score Need for the 3.5% Down Payment

It’s worth noting at this point that the FHA has certain requirements for the 3.5% down-payment program. Borrowers will need a FICO credit score of 580 or higher to qualify for the 3.5% level. Home buyers with scores below 580 will be required to put down at least 10% of the purchase price.

Of course, mortgage lenders often impose their own requirements on top of these. The industry term for this is overlays. Some lenders still require a credit score of 620 or higher for FHA loans, which makes the 580 cutoff sort of a moot point.

Changes We Know Are Coming

While the down payment increase is theoretical at this point, there are some forthcoming changes to the FHA loan program. Starting in April of this year, borrowers will have to pay more in mortgage insurance when using the FHA program. The annual premium will go up by a quarter of a percentage point. This is one of two insurance premiums the borrower must pay. The upfront premium (due at closing) will remain the same. The annual premium (that gets added onto the mortgage payment) is the one rising in April.

We could also see lower limits for FHA loans, starting around October 2011. That’s when the current loan limit of $729,750 expires. It has been proposed that the limit be dropped to $625,500. The Obama administration is on board with this change, and Congress is expected to back it without much drama. The idea here is simple. The FHA loan program was originally intended for lower-income borrowers — responsible borrowers who don’t have a lot of money for a down payment. Which begs the question: What kind of lower-income borrower buys a home in the $700,000 range?

Some critics argue the government should go further, lowering the FHA loan limits to $500,000 or less. For now though, it’s baby steps. October will likely bring a decrease from $729,750 to $625,500.

Are higher down payments next on the agenda? Time will tell.

Wells Fargo FHA Loans: Subprime Borrowers Welcome?

FHA logoYesterday, the New York Times reported that Wells Fargo is changing its minimum credit-score requirement for FHA loans. And it’s a big change. Previously, Wells Fargo required borrowers to have a FICO credit score of 600 or higher, to qualify for an FHA loan. They recently lowered that cutoff to 500.

This matches HUD’s minimum requirement, which was set at 500 last year.

Some definitions are in order:

  • FICO score: This is a credit score that’s produced using the FICO scoring model, designed by the Fair Isaac Corporation. The scale goes from 300 to 850, with higher being better. This is the credit score used by most mortgage lenders when reviewing loan application (and making approval decisions).
  • FHA loan: This is a mortgage loan that’s insured by the federal government, under the management of the Federal Housing Administration (FHA). The FHA falls under the Department of Housing and Urban Development, or HUD. These loans are made by lenders in the primary mortgage market, such as Wells Fargo. The FHA insures them against losses resulting from borrower default.
  • Wells Fargo: The largest mortgage lender in the United States, having funded $387 billion worth of home loans in 2010.

If Wells Fargo grants FHA loans to home buyers with credit scores in the 500 range, it once more opens the door for subprime borrowers. That door has mostly been closed since the housing market crashed. It’s still closed in the conventional mortgage market, where loans aren’t backed by government.

This means that borrowers who are considered “subprime” by lending standards could once again qualify for a home loan. Such borrowers would find it nearly impossible to qualify for a conventional mortgage loan these days. It could also lead to another surge in FHA loans, at a time when the Obama administration is trying to reduce the government’s footprint in the mortgage market.

Credit Score Overlays on FHA Loans = Confusion

Lenders have long imposed their own standards on top of the FHA’s minimum requirements. Credit scores are a good example of this. According to FHA requirements, borrowers must have a credit score of at least 500 to qualify for an FHA loan. If they want to qualify for the 3.5% down-payment program (which most buyers do), they must have a score of 580 or higher. But until recently, these minimum scores were moot because most lenders required higher scores than the FHA. These are referred to as credit score overlays.

Remember, when you apply for an FHA home loan, you must do it through a lender in the primary market (such as Wells Fargo, BOA, a state or local bank, etc.). So you essentially have to meet two sets of requirements — the lender’s and the FHA’s. In the case of Wells Fargo, it seems those requirements are becoming more closely aligned. Wells Fargo has essentially lowered their minimum credit-score requirement to the one already used by the FHA.

Related story: FHA insurance premiums will rise in April 2011

Your Score Also Determines Your Down Payment

Under current FHA guidelines, a borrower with a FICO credit score below 580 must put at least 10% down on the loan. Borrowers with scores of 580 or higher could put as little as 3.5% down. On a $200,000 mortgage loan, this is the difference between a down payment of $20,000 and $7,000, respectively. So while a subprime borrower might still qualify for an FHA loan through a lender like Wells Fargo, they’ll have to bring more money to the table.

This is a major development. The country’s largest mortgage lender is opening the door to a sea of borrowers who were kept on the sidelines until now. I’m eager to see how it all plays out. You can expect updates to this story in the coming weeks.

FHA Mortgage Insurance to Increase in April 2011

Judging by the emails we’ve received lately, the FHA’s latest announcement has created a lot of confusion among home buyers. It has to do with FHA mortgage insurance premiums, and a scheduled increase that will take effect in April 2011. Here’s what you need to know:

FHA logoIn November of last year, the Department of Housing and Urban Development (HUD) increased the annual mortgage insurance premium for FHA home loans. They did this to bolster the FHA’s capital reserves, which shrank below congressionally mandated levels during the housing bust.

They must have run the numbers again and determined the original increase was not enough. Because they’re about to do it again. Starting this spring, the annual mortgage insurance premium (MIP) for FHA loans will rise another quarter of a percent (0.25). See “overview of increases” below for more details.

FHA Commissioner David Stevens said the latest step was needed to maintain the capital reserve requirements set forth by Congress. These reserves are used to cover losses resulting from borrower default. The FHA insures home loans against such losses. That’s the whole point of the program. Stevens said the move still allows the “FHA to remain the most cost effective mortgage insurance option for borrowers with lower incomes and lower down payments.”

Overview of Premium Increases

These changes will apply to most FHA loans that are insured after April 18, 2011. At that point, the following MIP standards will be in place:

  • 30-year FHA loans will have an annual MIP of 1.1 to 1.15 percent of the loan amount.
  • FHA loans with a term of 15 years or less will have an annual MIP of 0.25 to 0.50 percent.

Note that these changes only apply to the annual mortgage insurance premium for FHA loans. The upfront premium remains the same. There are two types of mortgage insurance on FHA loans: an upfront premium that gets paid at closing, and the annual premium that gets rolled into the monthly mortgage payment.

The April 2011 increase will only affect the annual premium. So the increased amount gets added onto the borrower’s mortgage payments — it’s not added to the upfront costs. In fact, the upfront insurance premium was actually decreased last year. The FHA did this to minimize the borrower’s upfront costs, while increasing the total amount of insurance paid over the term of the loan.

Related: 2011 FHA requirements for home buyers

Don’t be confused by the similar terminology. Here’s what it boils down to. When you use an FHA home loan to buy a house, you will have to pay two forms of insurance on the mortgage loan.

  1. The upfront insurance premium is 1 percent of the loan amount, and you must pay it at closing (in most cases). There are currently no increases planned for the upfront portion.
  2. The annual premium is added onto your monthly payments. In April 2011, this premium will increase to the amounts mentioned earlier: 1.1 – 1.15 percent for 30-year loans, and 0.25 – 0.50 percent for shorter loans.

This premium increase applies to most mortgages insured under the FHA single-family loan program. But certain programs are excluded:

Mortgage Loans Not Affected by the Increase

The increase does not apply to Title I Loans (home improvement), reverse mortgages under the FHA’s Home Equity Conversion Mortgage program, or any loans made under the HOPE for Homeowners program. Additionally, the FHA mortgage insurance increase does not apply to loans made in the following areas:

  • Section 247 (Hawaiian Homelands)
  • Section 248 (Indian Reservations)
  • Section 223(e) (Declining Neighborhoods)
  • Section 238(c) (Military Impact areas in Georgia and New York)

FHA Mortgage Insurance Scenario

Here’s an example of how the FHA mortgage insurance premiums works. Let’s assume I take out an FHA home loan for $200,000. My upfront MIP is 1 percent, which in this case amounts to $2,000. I would likely have to pay this amount at closing.

My FHA loan also gets assigned an annual MIP for 1.1 percent of the loan amount. This comes out to $2,200. This is an annualized cost that is paid monthly, on top of my mortgage payment. So I can divide $2,200 by 12 and get a monthly add-on of $183.

So I’m paying around $2,000 up front, and another $183 per month. Most of this goes toward the FHA’s capital reserves. This is a realistic scenario that shows how FHA mortgage insurance works.

How to Apply for an FHA Home Loan

Mortgage insurance is just one of several requirements for the FHA loan program. You’ll also need a decent credit score (580 or higher) and a down payment of at least 3.5 percent. Additionally, your debts cannot eat up too much of your monthly income. You can learn more about these requirements here. In order to apply for an FHA home loan, you should locate an FHA-approved lender in your area. You can find such lenders on this page of the HUD website.

2011 FHA Home Loan Requirements for Borrowers

Here’s what you really want to know:

If you are a home buyer thinking of using an FHA loan to buy a home, you should be aware of certain changes to the FHA program. This page offers a summary of FHA home loan requirements for 2011.

Note: There is an updated version of this article for 2012. Go there now

What is an FHA Loan?

An FHA home loan is a mortgage loan that’s insured by the Federal Housing Administration. The FHA is a federal agency that falls under the Department of Housing and Urban Development (HUD).

The government does not actually lend money to borrowers. Rather, they insure the loans made by primary lenders such as Wells Fargo and Bank of America. In order to participate in this program, a mortgage lender must be approved by the FHA.

The FHA insures the loan against losses resulting from borrower default. So if the borrower stops making payments on the loan, the FHA will cover the lender’s losses (as long as the loan was made in accordance with current FHA guidelines).

Credit Score Requirements for 2011

The first thing we need to talk about is your credit score. This is one of the most important FHA home loan requirements for 2011. In the past, the FHA did not establish any minimum requirements for credit scores. They mostly left it up to the lenders. But starting in 2010, HUD announced some new guidelines. In short, borrowers must have a credit score of 500 or higher to qualify for an FHA home loan. In order to qualify for the 3.5 percent down-payment program, the borrower must have a credit score of 580 or above.

But here’s the “catch.” The FHA’s minimum requirements for credit scores are actually lower than the guidelines used by most mortgage lenders. Most lenders will require you to have a score of 620 or higher, in order to qualify for an FHA home loan in 2011. For example, Wells Fargo and Bank of America announced at the end of 2010 that they were raising their minimum from 620 to 640, for most FHA loans.

Down Payment Requirements

When using an FHA loan to buy a home, you can put as little as 3.5 percent down. This is about the smallest down payment requirement you’ll find anywhere, aside from VA and USDA loans. This is also what makes the FHA home loan so popular among borrowers. In order to qualify for the 3.5 percent down-payment option, you’ll need a FICO credit score of 580 or higher. See the previous section for more information about FHA credit score requirements in 2011.

[See also: 20-percent down payment myth]

Debt-to-Income Ratios

A debt-to-income ratio is a comparison between the amount of money you earn each month, and the amount you spend on your various debts. These ratios use your gross monthly income, which is the amount you earn before taxes are taken out.

There are two ratios you need to know about:

  • The first one is your housing ratio, also known as the front ratio. It only accounts for your mortgage-related debt. In short, your monthly mortgage payment should not account for more than 29 percent of your gross monthly income. The math is fairly straightforward. Start with the total amount of your mortgage payment (including principal, interest, taxes and insurance), and then divide that number by your gross monthly income. If you come up with a number that’s higher than .29, or 29 percent, you might have trouble qualifying for an FHA loan in 2011. *
  • The second ratio is called the back-end ratio. It’s similar to the first, but it takes all of your other debts and credit lines into account (not just your mortgage-related debt). In this scenario, you must combine your monthly mortgage payments and all of your other monthly debt payments — car loan, credit cards, and other items that appear on your credit reports. Divide this number by your gross monthly income. If you come up with a number that’s higher than .41, or 41 percent, you might get turned down for the loan. *

* The above ratios are not set in stone. These are the general guidelines used for FHA loans, but allowances can be made for otherwise qualified borrowers. For example, if your front ratio is slightly higher than the FHA’s preference, but you have excellent credit, you might still be approved for the loan.

Debt ratios will be one of the key requirements for FHA home loans in 2011. So you should do the math now to find out where you stand. If your ratios are too high, you’ve got work to do.

[See also: Current FHA mortgage rates]

Mortgage Insurance Premiums

One of the drawbacks of using an FHA loan is that you’ll have to pay a mortgage insurance premium. Actually, you pay two premiums. There’s an upfront premium that is due at closing, as well as an annual premium that is paid monthly on top of your mortgage payment.

In 2010, the FHA made some changes to these two premiums. They increased the annual premium and decreased the up-front premium. This increases the total amount of insurance you’ll pay over the life of the loan, while lowering the up-front costs you must pay at closing. (Update: They will increase the annual premium again in April 2011.) When using an FHA loan in 2011, your annual premium will be 1.1 percent to 1.15 percent of the loan balance. The up-front insurance premium (a one-time payment) will be 1 percent of the loan balance.

Applying for an FHA Home Loan

Please note these are not the only FHA loan requirements for 2011. There are also exceptions to every rule. If you want to find out if you’re qualified for one of these mortgages, you’ll need to speak to an FHA-approved lender. This is how you would start the application process. You can find such lenders in your area on this page of the HUD website.

FHA Loans Took 40 Percent of Market Share in 2010

On Tuesday, the Department of Housing and Urban Development (HUD) released its annual report on FHA issues to Congress. Among other things, the report stated that FHA loans accounted for nearly 40 percent of all purchase mortgages, for the period of November 2009 – November 2010.

The Ups and Downs of FHA Market Share

In 2005, the FHA’s market share of purchase loans was closer to 5 percent (when measured by households served). So they are clearly insuring more loans today than just a few years ago. But if we go back even further, we can find a similar pattern. In 1993, FHA’s slice of the purchase-loan mortgage market was around 15 percent.

So what’s really going on here?

For the most part, the FHA’s market share has followed the alternating trends of relaxed and restricted lending. Whenever financial side-doors open up for people with bad credit and no money down, FHA’s market share goes down. When those doors close again, FHA loans become more popular.

This is what we saw in the late 1990s and early 2000s. Remember, this was the period when all of those “exotic” mortgage loans came into use — most of which are now extinct. The stated-income loan, the subprime mortgage, etc. “So long FHA. We don’t need you anymore. There’s a new game in town.”

But now that most of those high-risk (and low intelligence) mortgage products are gone, it’s a love affair with FHA loans once again.

By this time next year, FHA loans could easily account for more than 50 percent of all purchase mortgages. Our consumer research is already pointing toward this kind of usage spike. Time will tell.

FHA Loans 2.0 – They Aren’t “Easy” Anymore

Of course, even the FHA has limits to what it will do, in terms of lending. Over the last few years, the government agency suffered huge financial losses resulting from defaults and foreclosures. The so-called “seller-financed down payment assistance” mortgages cost the FHA more than $6 billion dollars in claims.

So the organization’s leaders took a step back to review their mortgage-insurance criteria. As a result of this review, there have been a number of changes to the FHA loan program. Borrowers today will need larger down payments (3.5 – 10 percent) and higher credit scores.

The FHA is also taking steps to restore its capital reserves. During the housing-market crash, those reserves fell below the 2-percent mark that is required by congress. They are restoring capital largely by requiring higher mortgage-insurance premiums over the term of the loan.

Related stories:

FHA logoAbout the FHA: The Federal Housing Administration (FHA) is part of the federal government, under the Department of Housing and Urban Development (HUD). This agency insures mortgage loans made by FHA-approved lenders in the primary mortgage market. They insure loans against default, which increases the lender’s willingness to lend. Since its inception in 1934, the FHA has been the largest insurer or mortgage loans. Learn more