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.