In the market for an FHA loan? You’re not alone. This program has become one of the most popular financing options for home buyers, especially for first-time buyers who don’t have much in the way of down-payment funds.
To get an FHA approval in 2014, you’ll need to have a pattern of responsible financial behavior. How do lenders measure this? With your credit reports and scores.
Much has been written about the importance of credit scores, when it comes to getting approved for a mortgage loan. In short, if this three-digit number is too low, the lender will probably turn you down. FICO credit scores serve as risk indicators. A higher number indicates a lower risk to the lender, and vice versa.
Credit reports, on the other hand, get less coverage. Maybe it’s because they’re not as “sexy” as those three-digit numbers. After all, they’re basically just a historical record of a person’s borrowing activity. Yawn!
In reality, your credit report can influence your FHA approval (or rejection) more than any other single factor. So now I have your attention. Here’s what you need to know about it.
Newsflash: Your Credit Report Drives Your FICO Score
Based on the emails we receive, it seems that mortgage shoppers are mostly concerned about their credit scores, while neglecting to look at the information in their credit reports. Many people don’t even realize they are two separate things (they are).
Your score is simply a three-digit number. It does not include any supporting information or “evidence” about your financial history. It doesn’t show late payments, credit card accounts, loan balances or delinquencies. That kind of detailed information can be found in your credit reports. So your chances of getting approved for an FHA loan will partly depend on the information contained in your reports.
The graphic above shows where your scores come from, and why you have three of them. It all starts with your financial activity — specifically, loans and credit cards. Your usage history gets compiled into a data file commonly referred to as a credit report. You have three of them, because there are three companies in the U.S. that collect this kind of information: Equifax, Experian and TransUnion.
Ultimately, the data gets fed through a computerized scoring system (such as the FICO scoring model) to produce a three-digit score. But it all comes from those credit reports.
Credit reports play a large role in FHA approval in 2014. Sure, lenders will look at your scores for the sake of convenience, and to make a quick assessment of your risk level. But they’ll also wade through the data in your reports. The government requires this. The Department of Housing and Urban Development (HUD), which manages the FHA loan program, requires lenders to carefully review a borrowers’ credit reports to measure their overall “attitude toward credit obligations.”
(Side note: If the borrower does not have a documented credit history for some reason, the lender must create one by reviewing utility payments, rental payments, car insurance payments, and the like. But this is the exception to the rule. Most FHA applicants have reports on file with the three companies mentioned above.)
Why FHA Cares About Your Credit Reports
Why do FHA officials and mortgage lenders care so much about credit reports? In a word, risk. These documents show how responsible or irresponsible you’ve been in the past, with regard to your finances. So they can be used for risk-assessment purposes. In short, mortgage lenders view credit reports as a reasonable indicator of your future payment performance, based on how you have acted in the past. It’s the next best thing to having a crystal ball.
Here’s what HUD says regarding credit report histories and FHA loan approval. The following quote comes from HUD Handbook 4155.1, Chapter 4, Section C:
Borrowers who have made payments on previous and current obligations in a timely manner represent a reduced risk. Conversely, if a borrower’s credit history, despite adequate income to support obligations, reflects continuous slow payments, judgments, and delinquent accounts, significant compensating factors will be necessary to approve the loan.
Translation: Even if you have sufficient income and assets to qualify for an FHA loan in 2014, a documented disregard for debt obligations could hurt your chances of getting approved. If you have one negative item on an otherwise spotless history, it’s probably not a deal breaker. But if you have an overall pattern of negligence, you’ll encounter some roadblocks. Key word “pattern.”
Don’t Sweat the Small Stuff: It’s the Pattern That Matters
As mentioned above, a single blemish on an otherwise “clean” credit report won’t necessarily kill your chances of getting an FHA loan. On the contrary, the program was designed for people with small down payments and less-than-perfect histories.
Here again is HUD Handbook 4155.1:
“When analyzing a borrower’s credit history, the underwriter must examine the overall pattern of credit behavior, not just isolated occurrences … A period of past financial difficulty does not necessarily make the risk unacceptable, if the borrower has maintained a good payment record for a considerable time period since…”
Credit card late payments are a good example. The FHA allows mortgage lenders to make common-sense decisions about borrowers. For instance, if your credit history shows one or two late payments within a narrow window of time, followed by a sterling payment history for the remainder, it probably won’t derail your home loan. In this kind of scenario, a simple letter of explanation (LOE or LOX) might be enough to get an FHA loan approval.
A pattern of late payments, on the other hand, shows you are either unwilling or unable to repay your debt obligations. This could be a deal breaker, unless the underwriter can find and document significant compensating factors.
Bottom line: Your credit reports partly determine whether or not you can get approved for an FHA loan. They influence your FICO score, and they show how you have managed your finances (particularly loans and credit) in the past. This makes them a critical item during the mortgage application and approval process. Don’t be left in the dark. Check your credit reports today to make sure they are error-free. Find out if they contain any negative information, such as late payments, delinquencies, debt collections and the like. If they do contain these things, you’ve got some explaining to do.
Brandon Cornett is a veteran real estate market analyst, reporter, and creator of the Home Buying Institute. He has been covering the U.S. real estate market for more than 15 years. About the author