Wells Fargo FHA Loans: Subprime Borrowers Welcome?

FHA logoYesterday, the New York Times reported that Wells Fargo is changing its minimum credit-score requirement for FHA loans. And it’s a big change. Previously, Wells Fargo required borrowers to have a FICO credit score of 600 or higher, to qualify for an FHA loan. They recently lowered that cutoff to 500.

This matches HUD’s minimum requirement, which was set at 500 last year.

Some definitions are in order:

  • FICO score: This is a credit score that’s produced using the FICO scoring model, designed by the Fair Isaac Corporation. The scale goes from 300 to 850, with higher being better. This is the credit score used by most mortgage lenders when reviewing loan application (and making approval decisions).
  • FHA loan: This is a mortgage loan that’s insured by the federal government, under the management of the Federal Housing Administration (FHA). The FHA falls under the Department of Housing and Urban Development, or HUD. These loans are made by lenders in the primary mortgage market, such as Wells Fargo. The FHA insures them against losses resulting from borrower default.
  • Wells Fargo: The largest mortgage lender in the United States, having funded $387 billion worth of home loans in 2010.

If Wells Fargo grants FHA loans to home buyers with credit scores in the 500 range, it once more opens the door for subprime borrowers. That door has mostly been closed since the housing market crashed. It’s still closed in the conventional mortgage market, where loans aren’t backed by government.

This means that borrowers who are considered “subprime” by lending standards could once again qualify for a home loan. Such borrowers would find it nearly impossible to qualify for a conventional mortgage loan these days. It could also lead to another surge in FHA loans, at a time when the Obama administration is trying to reduce the government’s footprint in the mortgage market.

Credit Score Overlays on FHA Loans = Confusion

Lenders have long imposed their own standards on top of the FHA’s minimum requirements. Credit scores are a good example of this. According to FHA requirements, borrowers must have a credit score of at least 500 to qualify for an FHA loan. If they want to qualify for the 3.5% down-payment program (which most buyers do), they must have a score of 580 or higher. But until recently, these minimum scores were moot because most lenders required higher scores than the FHA. These are referred to as credit score overlays.

Remember, when you apply for an FHA home loan, you must do it through a lender in the primary market (such as Wells Fargo, BOA, a state or local bank, etc.). So you essentially have to meet two sets of requirements — the lender’s and the FHA’s. In the case of Wells Fargo, it seems those requirements are becoming more closely aligned. Wells Fargo has essentially lowered their minimum credit-score requirement to the one already used by the FHA.

Related story: FHA insurance premiums will rise in April 2011

Your Score Also Determines Your Down Payment

Under current FHA guidelines, a borrower with a FICO credit score below 580 must put at least 10% down on the loan. Borrowers with scores of 580 or higher could put as little as 3.5% down. On a $200,000 mortgage loan, this is the difference between a down payment of $20,000 and $7,000, respectively. So while a subprime borrower might still qualify for an FHA loan through a lender like Wells Fargo, they’ll have to bring more money to the table.

This is a major development. The country’s largest mortgage lender is opening the door to a sea of borrowers who were kept on the sidelines until now. I’m eager to see how it all plays out. You can expect updates to this story in the coming weeks.