It can be confusing when you hear or read that people can get an FHA mortgage with 500 credit scores. Is it true, and if it is, how is that possible?
“It was 2006 the last time we did a loan for someone with a 500 credit score. But that was back then, and almost anyone could get a loan,” says Brad Boden, executive vice president at A and N Mortgage Services in Chicago. “You have to have a lot of things going wrong with a 500 credit score. Hence, that’s why we had problems in the mortgage world back then. Now, it’s a little tougher than that to get a loan.”
However, if you read the guidelines in the official FHA handbook written by FHA’s program manager – the Department of Housing and Urban Development or HUD – you’d think people could get a loan with such low credit scores.
Boden explains it like this — Lenders can put their own guidelines on top of the FHA guidelines.
“Those are called overlays. FHA says you can go down to a 580 credit score. However, we are a bank. We fund the loans, and we work with 25 other banks. Out of those, we have only one that will go below 620 on an FHA loan, and most of them prefer 640,” he says.
FHA Minimum Credit Score
Most lenders will turn away potential borrowers even if they have a 580, he says. They might work with them to help them raise their credit score or give them advice on actual things they can do to improve it, and tell them to come back in a few months.
The official handbook also stipulates that borrowers with credit scores between 500-579 would be limited to a maximum loan-to-value of 90 percent instead of being eligible for maximum financing with an FHA loan. What that means is that the borrower must put down 10 percent if they can get approved at all. Those with a 580 and above credit score are only required to put down at least 3.5% of the sale price or the appraised value (whichever is less).
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But Boden says he doesn’t know any lenders at this time who would take on a borrower with those low of scores despite the fact that FHA loans are guaranteed even if the borrower defaults on the loan.
On the other hand because of that guarantee by the government, some lenders allow for borrowers with other problems listed on their credit history. It all depends on the lenders’ set of overlays. For instance, the debt requirements could be a little more relaxed with some lenders than their tougher credit score requirements for FHA loans. A borrower’s total monthly debt load (that’s everything from student loans to auto loans) should add up to no more than 43% of his or her gross monthly income.
Debt-to-Income (DTI) Ratio Affects Credit Score Requirement
Borrowers with credit scores below 620, and total debt-to-income (DTI) ratios above that 43% mark, could face more scrutiny during the loan process.
According to the Consumer Financial Protection Bureau (CFPB), you calculate your debt-to-income ratio by adding up all your monthly debt payments and dividing them by your gross monthly income.
Gross income is the amount before taxes and deductions are removed. Let’s say your mortgage is $1,500, car loan is $100 a month and the rest of your debts are $400 a month. That’s an even $2,000 a month in debts. Your gross income is $6,000. That makes your debt-to-income ratio 33 percent ($2,000 is 33 percent of $6,000).
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“If I had someone come in with a 590 credit score, then you need to think like a bank and realize they just aren’t paying things on time,” Boden says. “Every FHA loan has to go through automated underwriting, just like conventional loans. They take into consideration your income, your credit, assets. They encompass everything.” Automated underwriting refers to the computer program that analyzes the borrower’s information, and recommends the file for approval, further review, or denial.
Conventional loans are pushing for over the 700 credit score. Plus, Boden says that you get the best interest rates with 740 and above.
With lower credit scores such as 600 or below, you have to have some strong compensating component such as a big down payment that will help your individual case, he says.
“FHA loans are still a great loan. The niche is that it offers you a low down payment and credit scores in the 600s. I do a lot of them, and I will continue to do a lot of them,” he says. “Everyone has their bumps in the road. With a 620 or 640 credit score, you had a small derogatory thing in the past like a Macy’s fee of $5 that you forgot to pay or didn’t even know about. But if you get into the 500s, it is a pattern of not paying on time or having other problems.”
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Many applicants are surprised that they can qualify for an FHA with their credit scores. As important, future home buyers find they can afford the down payment and monthly payment associated with FHA.
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