Homebuyers who have a credit score of 580 or better and a down payment of at least 3.5 percent of the home's purchase price might seem like good candidates for an FHA loan, insured by the Federal Housing Administration. But whether these borrowers will qualify for such a loan isn't quite so simple.
On paper, the FHA allows a minimum credit score of 500 if the borrower makes a down payment of at least 10 percent of the purchase price. Borrowers whose scores are 580 or higher can qualify with a 3.5 percent down payment.
But the vast majority of lenders require a credit score of at least 640, regardless of the down payment, according to Joe Metzler, a mortgage specialist at Mortgages Unlimited in St. Paul, Minn.
"It's 640 or bust," he says.
That may be a something of an overstatement, since borrowers whose credit score is lower than 640 technically can get an FHA-insured mortgage. However, as Metzler points out, their choices of lenders, loans and interest rates likely will be limited and less attractive than those open to better-qualified borrowers.
A small minority of lenders, perhaps 5 percent to 10 percent by some estimates, will approve loans for such borrowers if the FHA's other requirements are met. The rest of the lenders add the stricter requirements, known as overlays, that make it more difficult for such borrowers to qualify.
The credit score overlay trips up the most borrowers, but dozens of other overlays also exist, and borrowers who escape one may have to confront another. For example, a lender that accepts a lower credit score and smaller down payment combination might prohibit the use of gift funds for down payments or tighten the allowable debt-to-income ratios. Many overlays apply only in rare situations.
Overlays are intended to ensure that loans are offered only to borrowers who have the ability to make the payments, according to Tom Goyda, a spokesman for Wells Fargo in St. Louis. "If you want to have a home loan and can sustain homeownership and afford the payments, we have to balance that with responsible underwriting and ensuring people can pay the loan according to the terms," he says.
Wells Fargo has recently loosened up its credit score overlays for borrowers who apply for a loan through the bank's retail branches.
While lenders are quick to defend overlays, mortgage and real estate brokers are eager to decry the extra restrictions. Metzler says overlays are "stupid" and "make no sense."
As FHA commissioner, David H. Stevens has challenged lenders to weigh the totality of each borrower's situation, rather than rely on the credit score as the primary criterion.
"We ask the industry to consider how to provide credit to these underserved borrowers by considering the reasons behind credit score impairment, as well as considering other factors, such as reasonable debt-to-income ratios, leveraged use of available credit and future job stability, combined with proper controls for owner occupancy, full documentation and primary residence," Stevens wrote in a Dec. 15 memorandum.
Stevens is leaving his post at the FHA and will become president of the Mortgage Bankers Association in June.
FHA overlays may have the greatest impact on borrowers who are on the margin of qualifying for an FHA-insured loan. That has prompted some critics to charge that overlays illegally restrict borrowers' fair access to home-loan credit.
The National Community Reinvestment Coalition has filed a complaint with the U.S. Department of Housing and Urban Development, or HUD, home of the FHA, alleging that 22 lenders' overlays violate the federal Fair Housing Act, Equal Credit Opportunity Act and Community Reinvestment Act. The coalition, based in Washington, D.C., is an association of community groups that promotes access to basic banking services.
HUD has said it will investigate the charges to ascertain whether these practices do, in fact, illegally deny qualified African-American and Latino borrowers access to FHA-insured loans.
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