Many home buyers who choose the FHA loan program are surprised to learn their credit scores are below the mortgage lender’s minimum cutoff, even though they meet the Federal Housing Administration’s official requirements. It happens fairly often, in fact, and it has to do with something called “overlays.”
According to the Department of Housing and Urban Development (HUD), which oversees the FHA program, borrowers need a credit score of 500 or above to qualify for an FHA loan in 2015 – 2016. However, to take advantage of the 3.5% down payment option, borrowers need a score of 580 or higher. But both of those numbers can be a moot point when mortgage lenders set the bar higher, as they often do.
In other words, the official FHA minimum credit score is sometimes too low for lenders.
How FHA Loans Work, Briefly
The Federal Housing Administration (FHA) does not lend money directly to home buyers pursuing a mortgage. Instead, they simply insure loans that are generated by lenders in the private sector.
It works like this. You approach ABC Mortgage Company to apply for an FHA loan. After reviewing your credit and income situation, the lender gives you the money you need to buy the house. The FHA, a federal agency that operates under HUD, insures ABC against financial losses that might occur if you default on (stop paying) your loan.
So while the FHA establishes the minimum credit score guidelines for the loan program, the lender can impose its own guidelines as well. They are the one lending the money, so it’s ultimately their call. And their guidelines might be stricter than those set by FHA. This is known as an “overlay” in industry jargon.
Minimum Credit Scores for 2016
The Department of Housing and Urban Development recently published HUD Handbook 4000.1, also known as the Single Family Housing Policy Handbook. This is the newly revised and official guide to FHA loan requirements and guidelines. Most of the handbook took effect in September 2015. Among other things, it explains the minimum credit score requirements for FHA loans in 2016.
- The absolute minimum is 500. To be eligible for the program, borrowers need to have a credit score of 500 or higher. Anything below that, and you are not eligible for the program.
- Home buyers with scores ranging between 500 and 579 are “limited to a maximum LTV of 90%.” This means they must make a down payment of 10% of the purchase price / appraised value.
- FHA borrowers with scores of 580 or above are “eligible for maximum financing,” according to HUD. This means they can finance up to 96.5% of the purchase, for a out-of-pocket down payment of only 3.5%.
Lender Overlays Can Be Even Higher
But here’s where those overlays comes into the picture. Home buyers with credit scores as low as 500 will likely have trouble qualifying for an FHA loan in 2016, even though they might meet the official cutoff. That’s because lenders can impose their own minimum scores, and their cutoff points are often higher than HUD’s minimum.
In the lender’s view, a borrower with a score of, say, 500 or 510 is a high-risk borrower. Scores usually drop into this range as a result of late payments, delinquencies, foreclosures, or other credit-related problems. In the lender’s view, these are all red flags that indicate a higher level of risk.
To make things even more complicated, different lenders have different standards for minimum FHA credit scores. It varies from one company to the next. Some set the bar at 580, while others might require a 620 or higher. The only way to find out is to ask a loan officer or apply for a loan.
At the beginning of 2015, the Home Buying Institute conducted an informal email survey of mortgage lenders across the U.S. The goal was to find out what kinds of scores they’re looking for, when qualifying applicants for FHA loans. While the standards varied from one company to the next, most of them wanted to see a minimum score of 600 – 620. We will conduct a similar survey at the beginning of 2016.
Average Score for Closed Loans in October: 687
Ellie Mae, a company that provides software for the lending industry, publishes an “Origination Insight Report” each month. The report compiles data from a “sampling of approximately 66 percent of all mortgage applications that were initiated on the Encompass origination platform.” As a result, it offers valuable insight into mortgage underwriting standards.
According to the company’s latest report, the average FICO credit score for closed (successful) FHA purchase loans in October was 687. That was the average for purchases, meaning loans that are used to actually buy a home. The average FICO credit score for FHA refinance loans was 654 in October. The average score for purchases has been fairly steady all year. The average for refinance loans, on the other hand, has dropped by 20 points since the beginning of 2015 (when it was at 674).
Note: This doesn’t mean borrowers need a credit score of 687 to buy a home with an FHA loan. It just means that the average score among closed loans was in that range. Still, it does give us some additional insight into the often murky world of mortgage underwriting.
The bottom line: Meeting the FHA’s requirements is not enough. You must also measure up to the mortgage lender’s guidelines, and these are often more strict than those set by the Federal Housing Administration.
Disclaimers: This story addresses the minimum credit score for FHA loans in 2016. This article was updated and fact-checked in November 2015, to reflect current program guidelines. For the latest and most accurate information on this loan program, we encourage you to visit the official HUD website at www.HUD.gov. Portions of this story were adapted from HUD Handbook 4000.1, which is available online. The information above may become outdated over time, so please refer to the official source(s) to learn more about this topic.