In December 2013, the Department of Housing and Urban Development (HUD) revised the guidelines mortgage lenders must use when manually underwriting FHA loan applications. The change will apply to FHA loans generated in 2014.
The revised underwriting guidelines are intended to help lenders evaluate the borrower’s level of risk. They are also meant to reduce stricter credit requirements (or “overlays”), which go above and beyond FHA’s minimum loan standards.
Translation: These underwriting changes could make it easier for some borrowers to obtain an FHA loan in 2014.
The revised underwriting guidelines were added to the Federal Register on December 11. This is standard procedure whenever a new guideline, rule or regulation is created at the federal level. It is the latest in a series of steps designed to restore and preserve the housing agency’s capital reserves, which were depleted by massive insurance payouts during the housing bust.
According the Federal Register entry, the revision is meant to provide “more definitive underwriting standards for [FHA] mortgage loan transactions that are manually underwritten.” In a widely distributed news release, HUD officials said they want to encourage “lenders to use a defined set of objective standards and ‘compensating factors’ in order to make responsible, risk-based underwriting decisions.”
Remember that phrase, compensating factors.
Manual vs. Automated FHA Underwriting
These changes apply to manual underwriting in particular, as opposed to the automated version. Manual underwriting is when the mortgage lender (specifically, the lender’s underwriter) reviews the loan documents and criteria manually, to determine if the borrower is qualified for an FHA loan. This distinguishes it from automated underwriting, which is performed electronically by a program known as FHA TOTAL Scorecard.
Manual underwriting is often used for borrowers who are marginally qualified, as well as those who have some sort of “red flag” such as a low credit score or high debt-to-income ratio. It’s the lender’s way of taking a closer look at the application file, with human eyes.
‘Compensating Factors’ Create Exceptions to the Rules
Compensating factors are a key component of the revised underwriting standards for 2014. Every borrower considering an FHA loan should understand the concept of compensating factors. They are basically exceptions to a rule.
Here’s an example. HUD has specific guidelines for debt-to-income (DTI) ratios for FHA borrowers. HUD Handbook 4155.1 states that a borrower’s total DTI ratio should not exceed 43%. But it goes on to state that mortgage lenders can still qualify such borrowers if they identify and document certain compensating factors, such as significant cash reserves or a history of timely mortgage payments.
The latest revision to FHA underwriting standards creates additional compensating factors for borrowers. This in turn will make financing available to a larger pool of borrowers, including some borrowers who may have been turned down in the past.
Broader Allowances for Debt-to-Income Ratios
This revision brings several changes to manual underwriting procedures, mostly where credit scores and DTI ratios are concerned.
HUD’s current guidelines for DTI ratios are often expressed as “31/43.” The front-end, or housing, ratio may not exceed 31%. The back-end, or total, debt ratio may not exceed 43%. But exceptions can be made for borrowers with compensating factors. The big change here is that these all-important compensating factors will now be available to a larger pool of borrowers, specifically those with credit scores of 580 or higher.
Here are the key points from this rule revision:
- These changes provide manual underwriting guidelines for FHA borrowers “who exceed the 31% housing-to-income ratio, yet carry little or no discretionary debt and, therefore, do not exceed the maximum 43% debt-to-income ratio” associated with FHA loans.
- HUD has created additional compensating factors that mortgage lenders can use to approve borrowers who exceed the maximum housing payment and debt-to-income ratio.
- HUD has lowered the credit-score cutoff for citing compensating factors. Under the current rules, borrowers with credit scores below 620 cannot benefit from compensating factors as a path to approval. This change will lower that cutoff point to 580.
- Once this change takes effect (sometime in 2014), borrowers with credit scores of 580 or higher may be approved for an FHA loan with debt-to-income ratios of 37/47 (with one compensating factor) or up to 40/50 with two compensating factors. Borrowers with scores below 580 may not exceed the standard 31/43 ratios.
Bottom line: The revised manual underwriting guidelines will “expand the pool of eligible borrowers who may qualify for the use of such compensating factors.” This change will give lenders more flexibility when qualifying borrowers, particularly those with below-average credit scores, or above-average debt ratios. This revision will apply to purchase loans as well as “credit qualifying FHA refinance transactions.”
Effective date: This revision will apply to loans with case numbers assigned on or after April 21, 2014. For more information on the new FHA underwriting guidelines for 2014, refer to HUD Mortgagee Letter 2014-02.