The FHA is introducing new guidelines on loan to value ratios and the minimum credit score required for FHA borrowers. As detailed in a Mortgagee Letter from the Department of Housing and Urban Development (HUD), the following credit requirements will apply for FHA borrowers, effective October 4, 2010.
- To be eligible for maximum financing, borrowers will need a minimum credit score of 580 or higher.
- Borrowers with a credit score between 500 and 579 will be limited to a loan to value of 90%. A sub 580 FICO credit score borrower will henceforth need to make a 10% minimum down payment on a purchase transaction.
- All borrowers with a credit score below 500 will not be eligible for FHA-insured mortgage financing.
HUD’s newly introduced minimum credit score and loan to value requirements will apply to all single family loan programs, except for Reverse Mortgages (Home Equity Conversion Mortgages) and Hope for Homeowners.
The new credit requirements are not expected to dramatically change the number of FHA mortgage approvals. Most lenders had already imposed a minimum credit score requirement of 640 or higher for FHA borrowers. In limited cases, borrowers with scores between 620 and 639 could still obtain mortgage approval.
Many potential FHA borrowers with scores below 640 who cannot obtain mortgage approval may be left wondering why this is the case if the FHA has established a minimum score of only 580. The explanation for this is that the FHA does not make mortgage loans but rather insures FHA loans made by lenders. Despite the FHA insurance, banks do not have an iron clad protection from loss.
To protect themselves from loss exposure, FHA lenders impose various requirements that may include establishing higher minimum credit scores. Some of the factors that influence banks in their assessment of risk on FHA loans are discussed below.
More and more banks are increasing the minimum credit score on FHA loans to attract a better overall execution (sales price) on their securities which improves profitability. Nonetheless, the increase in the minimum credit score isn’t always about protecting the bank on a potential future loss. In a lot of cases a bank feels more comfortable with a profit model that positions itself as a mortgage seller with a higher weighted average credit score on their pool for many other factors.
A credit score is an 18 month predictive measure of future performance but is not as reliable when a state or region is hit by some unpredictable negative economic factor. An increase in the minimum credit score can be used as an override to protect against losses resulting from a sudden downturn in the economy.
Each bank executes a contract of sale with defined representations and warranties on their future liability. The penalty (or loan buyback provision) is legally defined in the contract between seller and buyer of the loan. However, not all contracts are the same with regard to liability issues. When a loan default occurs, a post closing quality control review takes place. If the loan originator was negligent with respect to due diligence, the bank is subject to full recourse provisions and required to repurchase the loan which usually results in large losses to the bank. An example of this occurred recently when Bank of America (BAC) announced that Fannie Fae (FNMA.OB) and Freddie Mac (FMCC.OB) were demanding $10 billion of loan repurchases.
Given the complexities and potential losses to banks on the origination and sale of FHA loans, it is unlikely that banks will be decreasing their minimum credit score requirements any time soon.