In September, the FHA’s brand-new Single Family Housing Policy Handbook went into effect. This handbook replaces a number of previously issued policy letters and guides. It is meant to clarify the rules and requirements pertaining to FHA loans and the borrowers who use them.
The new handbook offers guidelines for the “downgrading” of borrowers who have $1,000 or more in disputed derogatory credit accounts. Borrowers who fit this description must have their loan application files manually underwritten by the mortgage lender’s underwriter. The underwriter must then find enough justification to approve the FHA loan, in spite of the derogatory credit issue.
In other words, borrowers who trigger this red flag will have more hoops to jump through — and a higher likelihood of loan denial.
To get a clearer picture of these rules, we dug into the handbook itself. The portions relating to late payments and the $1,000 derogatory credit rule can be found in section II-A-4, entitled “Underwriting the Borrower Using the TOTAL Mortgage Scorecard.”
The $1,000 Rule for Late Payments and Derogatory Credit
According to the new handbook, mortgage lenders must “downgrade and manually underwrite” any FHA-insured mortgage loan that received an “Accept” recommendation if the borrower has $1,000 or more collectively in disputed derogatory credit accounts.
The handbook offers a specific definition of “derogatory accounts,” and it includes late payments that occurred within the last two years. The official definition: “Disputed Derogatory Credit Account refers to disputed Charge Off Accounts, disputed collection accounts, and disputed accounts with late payments in the last 24 months.”
Borrowers who fall into one or more of these categories cannot be automatically approved the the FHA automated underwriting system. Instead, the underwriter must manually review the file to see if the borrower is reasonably qualified in all other areas.
In cases where there are multiple borrowers named in the application (such as two spouses purchasing a home together), the $1,000 limit is applied collectively.
Some exceptions: Disputed medical accounts and derogatory credit resulting from unauthorized use (like identity theft or card theft) do not count toward the $1,000 limit mentioned above. The mortgagee / lender can exclude such accounts if they provide proper documentation.
Manual Underwriting Doesn’t Necessarily Mean You’ll Be Denied
Being “downgraded” to manual underwriting doesn’t necessarily mean the loan will be denied. There are exceptions and workarounds for many of these FHA rules and requirements. It simply means that the lender’s underwriter or underwriting department must manually review the file to determine whether or not the borrower is qualified in other regards.
The new FHA handbook offers the following guidelines for a manually underwritten loan:
“The underwriter must review each Mortgage as a separate and unique transaction, recognizing that there may be multiple factors that demonstrate a Borrower’s ability and willingness to make timely Mortgage Payments … The underwriter must evaluate the totality of the Borrower’s circumstances and the impact of layering risks on the probability that a Borrower will be able to repay the mortgage…”
There are some key phrases included in the above quote, and scattered elsewhere throughout the new handbook. Here are some recurring themes we’ve encountered:
- “Multiple factors” — FHA encourages underwriters to consider multiple factors relating to the borrower’s ability to repay the loan. So a single derogatory issue won’t necessarily derail the loan.
- “Totality” — FHA encourages underwriters to look at the big picture — or the “totality” — of the borrower’s situation. If a borrower is well qualified in all other areas, they could still be approved for an FHA loan, even if they have more than $1,000 in late payments or other disputed derogatory credit.
- “Probability” — If documentation and financial analysis show a strong probability that the borrower will be able to repay the mortgage loan, exceptions can be made.
To be clear, being downgraded to manual underwriting could certainly slow the process down. And it might increase the chance of rejection. But it’s not an automatic death sentence for the loan. Underwriters tend to make decisions based on the big picture.
Learn more: If you would like to learn more about this aspect of FHA underwriting, refer to HUD Handbook 4000.1, the Single Family Housing Policy Handbook. You can find this handbook online at Allregs.com. A PDF version of the document is available at HUD.gov.