New FHA Rules for Bad Credit and High Debt Ratios (2015 Update)

The Department of Housing and Urban Development (HUD) has published a new handbook for FHA loans. Most sections of the Single Family Housing Policy Handbook, as it’s know, took effect earlier this week. So it is now the law of the land.

We’ve been plugging our way through this 867-page document, keeping an eye out for major changes to the FHA program. So far, it seems that most of the big changes are administrative in nature (filing and reporting procedures, paperwork, etc.). In other words, they apply mostly to mortgage lenders — not borrowers.

But the new handbook does offer some additional clarification borrowers may find helpful. FHA credit scores and debt-to-income ratios are one example. Here are the latest rules for these two important criteria, as of September 2015.

FHA Rules for Low Credit Scores & High Debt Ratios

The new handbook explains how mortgage underwriters should handle borrowers who have a combination of (A) relatively low credit scores, and (B) relatively high debt ratios.

In short, when a borrower’s credit score falls below a certain threshold — and his or her debt-to-income ratio is above a certain level — the lender must manually underwrite the mortgage loan. Not only does this delay the process. It also increases the chance for snags, additional paperwork hurdles, and even a loan rejection.

The handbook can be a bit confusing. Here’s the simplified version. HUD has a “soft” rule regarding debt-to-income ratios. They state that says a borrower’s mortgage-payment-to-income ratio should be no higher than 31%, and that the borrower’s total debt should use no more than 43% of his/her income. This is often referred to as the 31/43 rule for FHA debt-to-income ratios.

Additionally, HUD has certain rules regarding credit scores for borrowers who use FHA loans. Borrowers with scores below 500 are generally not eligible for the program. Borrowers with scores between 500 and 579 could still be eligible, but they’ll likely face additional scrutiny during the underwriting process (not to mention a larger down payment).

Likewise, borrowers who have credit scores above 580 (a good thing), but debt-to-income ratios above the 31/43 threshold explained above (a bad thing), must undergo manual underwriting.

Compensating Factors to the Rescue

Borrowers with low credit scores and/or high debt ratios often cannot receive an “auto approval” through the FHA’s automated underwriting system. Instead, the mortgage lender’s underwriter must manually review the file in order to identify “compensating factors” that make up for the low credit score and/or the higher-than-allowed debt ratios. When borrowers are weak in one area, they have to be extra strong in another.

Confused? Here’s a tabular perspective that might help. The following table was adapted from HUD’s Single Family Housing Policy Handbook, parts of which took effect on September 14, 2015.

Credit Score * Maximum Qualifying Ratios Acceptable Compensating Factors
500-579 or No Credit Score 31/43 Not applicable. Borrowers with Minimum Decision Credit Scores below 580, or with no credit score may not exceed 31/43 ratios. (Energy Efficient Homes may have stretch ratios of 33/45.)
580 and above 31/43 No compensating factors required. (Energy Efficient Homes may have stretch ratios of 33/45.)
580 and above 37/47 One of the following: verified and documented cash Reserves; minimal increase in housing payment; or residual income.
580 and above 40/40 No discretionary debt.
580 and above 40/50 Two of the following: verified and documented cash Reserves; minimal increase in housing payment; significant additional income not reflected in Effective Income; and/or residual income.

* In this context, the credit score used by lenders is the “Minimum Decision Credit Score” defined by HUD. Here’s the official definition from HUD Handbook 4155.1:

“A ‘decision credit score’ is determined for each applicant according to the following rule: when three scores are available (one from each repository [TransUnion, Experian, and Equifax]), the median or middle value is used; when only two are available, the lesser of the two is chosen; when only one is available that score is used.”

The bottom line: HUD has a lot of rules regarding FHA loans and the borrowers who apply for them. But many of these rules have exceptions as well. Credit scores and debt ratios are a good example. Borrowers with credit scores between 500 and 579 could theoretically be approved for an FHA loan, but they might face additional scrutiny. Similarly, borrowers with debt ratios above the 31/43 rule might still qualify for an FHA loan if they have the compensating factors mentioned above.