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

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Update — The proposed rule regarding debt collections on FHA loans was rescinded by the Federal Housing Administration in June 2012.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 We have left the original article intact, below, as a historical reference.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)