FHA Loans: Credit Scores Loom Large as New Rules Take Effect

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New requirements for Federal Housing Administration-approved mortgages go into effect today, presenting potential roadblocks for homebuyers with collections or judgments in their credit histories. While lenders have recently been able to take significant economic events into account in processing loan applications, today's changes are a step in the opposite direction for loan accessibility.

The U.S. Department of Housing and Urban Development issued mortgage letters Aug. 15 instructing lenders to add collections accounts and judgments to an applicant's debt-to-income ratio, one of the qualifying standards for an FHA loan. Loans made on and after Oct. 15 must follow these guidelines.

What Lenders Need to Look At: Charge-offs and medical collections are not included in these new standards, though they have a negative impact on credit scores and will therefore be factors in consumers' credit-worthiness. For an applicant with more than $2,000 in collections accounts, the lender is required to incorporate those debts into the debt-to-income ratio, because paying those debts may interfere with the ability to make mortgage payments.

"It's very dramatic because typically FHA has been geared toward people with less than perfect credit," said Eddie Hilliard, a loan originator at Mortgage Acceptance Corp. in Florida. "Now for them to not only have to explain away the collections and judgments but to add them to the debt ratio -- it's really going to put them out of sorts."

Collections accounts do not need to be paid off in order to qualify for an FHA loan, but judgments do. An exception can be made to the judgment rule if the borrower can arrange a payment schedule.

Additional Obstacles: The squeeze potential homebuyers may feel will be compounded by another regulation that goes into effect Jan. 10, 2014. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the maximum debt-to-income ratio will be 43%.

"Now, depending on the Automated Underwriting System findings, you could go as high as 55 percent," Hilliard said. The AUS analyzes completed mortgage applications and applicants' credit histories to generate loan decisions. Some applications are manually underwritten to consider circumstances of the debt, and by the new guidelines, mortgage applications of consumers with disputed credit accounts of more than $1,000 must be manually underwritten.

Such adjustments are steps toward strengthening the FHA loan program, which has been stressed since helping to fill the gap created by the collapse of the subprime mortgage market.

In some states, the regulations reach farther. In the nine community property states, even if one goes about the mortgage process alone, a spouse's collections and judgments are factored into the debt-to-income ratio. (Those states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.)

For anyone going for an FHA mortgage, the key is to pay those debts: Any payments that can lower your debt-to-income ratio will help. Take stock of your credit profile by reviewing your free annual credit report and ways to strengthen your credit. The Credit.com Credit Report Card is a free tool that shows you which areas of your credit you need to work on, and there are several approaches that can help consumers reduce collections debt.

"The best option now is to get ahead and make your debts right," Hilliard said. Try to get a settlement, reach out to that creditor, make payments. You're going to have to start making arrangements to clear that credit up."

More from Credit.com:
Why You Should Check Your Credit Before Buying a Home
How to Get Pre-Approved for a Home Loan
How to Search for Your Next Home

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