An informal survey of more than 50 mortgage lenders has revealed the top three reasons for FHA loan rejection / denial in 2015. A bad credit score, excessive debt, and insufficient income are the three most common obstacles for mortgage borrowers seeking a government-insured home loan.
At the beginning of February, the Home Buying Institute began querying FHA-approved mortgage lenders across the United States to find out why potential borrowers were being turned away. The email survey was sent to several different types of lenders, all of which were approved to participate in the HUD 203(b) Mortgage Insurance program (more commonly referred to as the FHA loan program).
3 Biggest Reasons for FHA Loan Rejection or Denial
While there are many reasons why a person could be denied an FHA loan, the three most common factors identified in the survey were as follows:
- The borrower’s credit score was too low, indicating an unacceptable level of risk.
- The borrower carried too much debt already, relative to his or her income.
- The borrower’s income was insufficient to take on the desired loan amount.
These factors are in no particular order. The survey was not designed to measure the frequency of denial within each specific category, but only to identify the most common hurdles faced by borrowers. Home buyers who are considering the FHA loan program in 2015 would do well to evaluate themselves in these three areas.
Of course, before you can evaluate yourself, you need to know how mortgage lenders will evaluate you. So let’s take a closer look at these three reasons for FHA rejection.
1. Borrower’s Credit Score is Too Low for FHA Loan
If you own a TV, you’ve probably heard about credit scores. Those ubiquitous commercials tell us how important these three-digit numbers are in our daily lives. This is half true. If you never rely on financing and tend to pay cash for almost everything, your credit score is meaningless to you. But if you use credit cards, home loans, and other forms of third-party financing, your credit score is a pretty big deal.
When it comes to the FHA loan program, there are a couple of numbers you need to know. According to the Department of Housing and Urban Development (HUD), which is the Federal Housing Administration’s parent organization, borrowers need a credit score of at least 500 to be eligible for the program. That’s tier one. Tier two is this: You’ll need a score of 580 or higher to enjoy the low 3.5% down-payment option that comes with FHA loans.
This doesn’t mean everyone with a score above 500 or higher will qualify for the program. Far from it. Mortgage lenders can impose their own credit standards as well, and their standards are often higher than the government’s. According to a previous survey we conducted, most lenders have a cutoff at around 580 – 620 for FHA borrowers. Many borrowers fall below these cutoffs, which makes this one of the most common reasons for FHA loan denial or rejection.
Note: These numbers are not set in stone. Some lenders are willing to go lower than others, where credit scores are concerned. Additionally, a borrower who is strong in other areas may be allowed to have a lower score. The bottom line is that it’s the lender’s call, ultimately.
2. Borrower Carries Too Much Debt Relative to Income
Pop quiz. What is your current debt-to-income ratio? If you haven’t a clue, you’re not alone. Most Americans (including myself) could not answer this question.
But if you’re planning to apply for an FHA-insured mortgage loan in the near future, you should find out where you stand. Excessive debt is one of the top-three reasons for FHA rejection in 2015, as it was last year as well.
According to HUD, borrowers can have a total debt-to-income ratio as high as 43% and still qualify for an FHA loan. HUD Handbook 4155.1 states that:
“The relationship of total [debt] obligations to income is considered acceptable if the total mortgage payment and all recurring monthly obligations do not exceed 43% of the gross effective income.”
They also allow for certain compensating factors, so that lenders can qualify borrowers with DTI ratios above 43% if they are well-qualified in other areas. So the 43% “rule” is not necessarily a deal breaker for all borrowers. Still, it’s one of the top-three reasons for FHA loan denial in 2015.
3. Borrower’s Income Is Too Low for a Home Loan
Your monthly income is the other side of the DTI equation mentioned above. Having too much debt in relation to your income can kill your chances of qualifying for a home loan. But having insufficient income relative to the loan amount is another common reason for FHA denial.
This is an offshoot of an item #2 above, but it can pose a problem all on its own. For instance, borrowers with little to no existing debt could still be turned down for an FHA loan if they lack sufficient income to cover their down payments.
Compensating Factors: An FHA Borrower’s Best Friend?
Earlier I mentioned the “compensating factors” HUD allows for borrowers with high debt ratios. In short, a compensating factor is something positive that makes up for something negative.
For example, a borrower with a debt-to-income ratio slightly above the 43% “soft” limit stated above might still be approved for the program, if he or she has a long history of making mortgage payments on time, and/or a lot of cash reserves in the bank.
Well-qualified borrowers don’t need to fret over such things. If you have excellent credit, very little debt, and a strong income and employment history, you have nothing to compensate for. FHA denial or rejection is less of a concern for such borrowers.
On the other hand, if you feel you’re a marginal borrower in some way (credit score is a little low, debt levels are a bit high, etc.), you should learn more about HUD’s compensating factors. They might be your saving grace in avoiding an unpleasant FHA denial.
Compensating factors are spread throughout various HUD handbooks. We provided an overview of the most common examples back in 2013, and most of them still apply today.