Rule Breakers: How to Qualify for an FHA Loan With Excessive Debt

Guidelines issued by the Department of Housing and Urban Development (HUD) state that borrowers need to have debt ratios below a certain limit, in order to qualify for an FHA loan. But there are little-known exceptions to these rules.

Lenders can still approve borrowers with high debt-to-income ratios, as long as they find and document some kind of compensating factors. Those factors are outlined below.

Why Debt Is a Deal-Breaker for Some Borrowers

FHA loans are popular among home buyers because they allow for a down payment as low as 3.5%. This makes them especially popular among first-time home buyers, who often lack the funds needed for a larger down payment.

But these loans have become harder to obtain in the last few years, due to a series of program changes. One of those changes has to do with debt-to-income (DTI) ratios. In short, borrowers with too much debt may find it difficult, if not impossible, to qualify for an FHA loan.

Borrowers with DTI ratios above the FHA minimums may still qualify for the program, if they are well-qualified in other areas.

Lenders use DTI ratios as a risk-assessment tool. Statistically speaking, borrowers with higher debt levels are more likely to default on their mortgages down the road.

So lenders look at things like credit scores and debt ratios to measure the risk level of each individual loan applicant. Borrowers with higher debt levels may find it harder to qualify for an FHA loan.

I’ve been speaking in general terms. Let’s get specific. Here is what HUD Handbook 4155.1 says about the two types of debt ratios:

  • Front end: “The relationship of the mortgage payment to income [known as the front-end debt-to-income ratio] is considered acceptable if the total mortgage payment does not exceed 31% of the gross effective income.”
  • Back end: “The relationship of total obligations to income [known as the back-end debt-to-income ratio] is considered acceptable if the total mortgage payment and all recurring monthly obligations do not exceed 43% of the gross effective income.”

Source: HUD Handbook 4155.1, Chapter 4, Section F, “Borrower Qualifying Ratios”

So according to these rules, a borrower’s mortgage payment should not use any more than 31% of his or her gross monthly income. Additionally, total recurring monthly debts (including the mortgage) cannot exceed 43% of monthly income. Borrowers with higher debt levels may be unable to qualify for an FHA loan.

But there are exceptions to both of these rules. Lenders are intimately familiar with these exceptions, but few borrowers know about them. The HUD handbook goes on to state that lenders can approve borrowers with debt levels above these limits if “significant compensating factors are documented and recorded.”

In other words, borrowers with DTI ratios above the FHA minimums may still qualify for the program, if they are well-qualified in other areas.

You May Still Qualify for FHA: A List of ‘Compensating Factors’

Borrowers with higher-than-average debt levels may still qualify for an FHA loan, if the lender can document one or more of the following compensating factors.

  • Payment history: If, within the last year or two, the borrower has been able to handle mortgage payments equal to or greater than the estimated payments on the FHA loan, he or she may still qualify for the program.
  • Down payment: The minimum down payment for an FHA loan is 3.5%. But a larger down payment could create an exception to the debt rules mentioned above. Borrowers who make down payments of 10% or more may still qualify for a government-insured mortgage, even if their DTI ratios are higher than the stated limits.
  • Savings: Borrowers who have demonstrated a “conservative attitude toward using credit” in the past, and have the ability to accumulate savings, may also be given an exception.
  • Good credit: The borrower’s credit history can be used as a compensating factor, if it shows that he or she is likely able to afford a larger mortgage payment. The higher the credit score, the better.
  • Minimal increase: If the new loan will only result in a minimal increase in housing expense, compared to the borrower’s current housing expense, he or she may still qualify for an FHA loan.
  • Cash reserves: Exceptions can also be made for borrowers with substantial cash reserves in the bank. In this context, “substantial” means at least three months worth of mortgage payments will be left over after closing. The lender must verify and document these cash reserves, if they are to be used as a compensating factor. Additionally, the funds must be liquid or readily convertible to cash.
  • Pay raise: If the borrower has the potential for higher earnings due to verifiable job training or other professional advancement, he or she may still qualify for an FHA loan, even with higher-than-average debt levels.

Borrowers do not necessarily need to have all of these compensating factors. One or more may be sufficient for FHA qualification purposes. To learn more about these rule exceptions, refer to Chapter 4 of HUD Handbook 4155.1, which is available online.