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

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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.