Loan Modification

Is It Time To Raise FHA Credit Score Standards?

By Peter G. Miller

When it comes to the FHA program there’s a constant worry that FHA lending guidelines are not tough enough, that the FHA should require more from borrowers to hold down program risks.

It was in January that HUD said new FHA borrowers would need a credit score of at least 580 to borrow with 3.5% down, a score below the magic 580 would require a 10 percent up front.

Now we have the new FHA short refinance program for underwater borrowers, a program which has no possibility of working. This plan says that borrowers need at least a credit score of 500 to qualify, not that it will matter. (The program won’t work because the borrower must be current on the mortgage and the lender must be willing to reduce the mortgage balance by 10 percent. Why a lucid lender would agree to reduce the principal balance on a performing loan is entirely unclear.)

Why HUD has established such minimum credit score standards seems curious. In the case of the 580 requirement it’s certain that few buyers will have both a 580 credit score and enough cash to make a 10 percent down payment. As to the short refinance plan, a 500 credit score is so low that it’s difficult to see how a borrow with such credit would meet the rest of the program requirements.

More importantly, the HUD minimum standards are curious because the FHA loan program is attracting well-qualified borrowers. The latest data shows that the typical FHA borrower has a credit score of 697, a score which is respectable. Why then should the FHA consider scores anywhere near 500 or even 580?

Layering

It’s hard to imagine any lender who will take the FHA credit score minimums seriously. Remember, it’s HUD which is telling lenders that they must follow FHA guidelines precisely and those who fail can be kicked out of the program or fined, as more than 900 lenders found out in July.

Instead, lenders are likely to look at the FHA minimums, laugh, and then establish a higher standard to assure they do not run afoul of FHA loan guidelines, say 620 or 640 in today’s market, a process called layering.

New Minimums

Once you look at the credit scores FHA borrowers now have, and once you look at the layering concept, then it seems clear that the FHA should adopt higher minimum scores for buyers. The logic of such higher scores is that they tend to lower risk and, realistically, they are now in place. So how about a new minimum of say, er, 630?

For those refinancing FHA loans the standard needs to be different. If a performing borrower — one who is not late and does not miss payments — can refinance into a loan which has a lower monthly cost with no principal increase, then a credit score is less important than performance. Just by refinancing into a better mortgage the borrower’s credit score should improve. The required score for such a refinancing borrower? None needed.

Full post as published by FHA Mortgage Guide on August 16, 2010 (boomark / email).