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Credit Score for FHA Loan: What's the Minimum?

If you are thinking of buying a house, you may be wondering exactly what is the minimum credit score for an FHA loan. A quick Internet search can leave you more confused than before you started. Is it 500? 580? Or 680? Even HUD's own website can leave your head spinning.

Credit Score for FHA Loan: How Low Can You Go?

According to the Federal Housing Administration, the absolute minimum credit score you can have and still be eligible for an FHA loan is 500. Unfortunately for the credit-challenged, it's not that straightforward. The FHA is perfectly okay with horrible credit scores, but only if the applicant doesn't actually have horrible credit. If, the FHA says, an applicant with adequate income to support obligations has a pattern of slow payments, judgments, and delinquencies, it will take "significant compensating factors" to approve the loan. HUD's Quarterly report to Congress dated August 2014 indicates that less than one quarter of one percent of approvals went to borrowers with scores in the 500-579 range.

Credit scores from 500-579 do make you eligible for an FHA loan, but only if you are able to come up with a down payment of ten percent of the purchase price of the house. While it's less than the 20 percent down payment that may be required without an FHA loan (yes there are lower down payments out there but not for people with poor credit), it can still be a pretty high threshold for a home buyer. And even if you can cough up the ten percent down payment, it can be hard to find an actual lender willing to approve a home loan with credit scores that low.

What About a Minimum Credit Score Of 580?

Yes, 580 is the minimum credit score FHA allows for loans with a down payment of only 3.5 percent. Here, too, finding a mortgage lender willing to take the risk of loaning to someone with the very minimum allowable credit score may not be easy. According to mortgage tracking firm Ellie Mae, in June 2014 the average FICO score of approved FHA buyers was 686, and the average FICO of those denied loans was 661 -- considerably higher than the "official" minimum score. HUD reports that just 3.3 percent of FHA loan approvals went to applicants with credit scores between 580 and 619.

If you do find a lender willing to make the loan with a credit score at the lower end of what is allowed, the lender may have additional requirements, like a bigger down payment or higher interest rates, above and beyond the FHA guidelines. These extras are called "lender overlays."

Lender Overlays

Many lenders set their own limits at credit scores between 620 and 640, and some go as high as 680. This practice is called lender overlay. It means that while FHA's guidelines may be more flexible, FHA-approved lenders are allowed to "overlay" additional requirements before approving a home loan.

Why would lenders do this if FHA insurance protects them against losses in the event of a default? They do it to protect their status as FHA-approved lenders. If too many borderline borrowers default on their mortgages, the FHA can pull the lender's approval. The agency continuously monitors lender performance and compares each lender to all approved lenders in the area (they call this calculation a "compare ratio"). Lenders with higher-than-average default rates can lose their ability to fund FHA mortgages. A lender can lose its FHA approval even if its loans are written in exact accordance with FHA guidelines. Since FHA loans make up a large part of the mortgage market, losing FHA approval could devastate a lender's income.

This causes a cycle -- Lender A raises its minimum score to make sure its compare ratio is lower than those of neighboring lenders. This means the other lenders have to jack up their guidelines as well or risk being bounced from the program. Fortunately, the FHA has recognized how damaging compare ratios are to the market and is taking steps to combat the problem.

Credit Score For FHA Loan: Bottom Line

Overall, credit scores of FHA borrowers have been steadily on the rise over the last few years. They have jumped from an average of 621 in 2008 to an average of 700 in 2012, finally tapering a bit in 2014.

That doesn't mean you are out of luck if you have less than perfect credit. Mortgage requirements aren't uniform, even among FHA-approved lenders. If you are worried about how your credit score will impact your ability to get an FHA loan, start by contacting a number of lenders. Find out what their minimum requirements are and compare the terms of they are willing to offer.

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