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

Having a low credit score shouldn't be a reason to give up on your dream of home ownership. In fact, an FHA loan can be a great option when credit score requirements are an issue. Before you commit, you'll want to know what the real FHA loan credit score requirement is, if you qualify with your credit score, and, if not, what you can do to improve your credit score to qualify for an FHA mortgage.

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

The lowest FHA loan credit score needed to qualify under FHA regulations and guidelines is 500. Any credit score under 500 will be unable to qualify for an FHA home loan.

If you have a credit score in the range of 500 to 579, you will be asked to make a 10% down payment.

If your credit score is 580 or above, you will only need to make a 3.5% down payment.

Reality Check: FHA Loans for Bad Credit

Lender overlays are a process of FHA approved lenders setting their own extra layers of requirements and higher minimum FHA loan credit scores. Although the required minimum FHA credit score is 500, lenders and brokers do not always approve FHA loans for bad credit applicants. So, despite the lower credit score requirements allowed by the FHA, lenders approved by the FHA do not need to approve mortgages based on FHA credit requirements for home loans. They often set their own minimum FHA loan credit scores anywhere from 620-680, and their minimum credit score is typically what is needed in order to qualify for an FHA loan with that lender.

Examples of What Lender Overlays Look Like

Beyond the lender overlay related to the lowest FHA credit score, here are four other examples of potential lender overlays:

  • Credit history: The FHA itself does not disqualify applicants from getting an FHA loan with bad credit. The agency understands that you may have a short credit history, or have chosen not to use credit at all. Lenders, on the other hand, may require that you have a credit history for a particular time period, or if you have no credit history, they may look at your payment history in relation to your rent and utilities.
  • Employment history: The FHA also does not require any length of time for employment at a particular position or job. Lenders, however, may require that you have an employment history of at least six months at a single position and location.
  • Collections: To qualify for an FHA loan, there are no requirements set by the FHA to pay accounts in collections. However, lenders may require that they are paid off with a zero balance.
  • Debt-to-income ratio: Your debt-to-income ratio tells the lender what amount of debt you have in comparison to your income. The FHA guidelines may allow a DTI over 43%. Unfortunately, most lenders will not.

5 Reasons Why FHA Approved Lenders Use Lender Overlays

FHA approved lenders tend to use overlays for the following reasons:

  • Protection: If too many borrowers default, go into foreclosure, or continuously pay their mortgage late, lenders and brokers have to deal with the consequences. This could result in lenders losing their FHA approved status.
  • FHA approved status: Being able to offer an FHA loan to mortgage seekers enables lenders to do business with a wider population. Therefore, lenders and brokers need to keep their FHA approved status intact.
  • Lender and broker income: FHA-backed mortgages provide those who would not qualify for a conventional loan the ability to pursue their dreams of home ownership. Losing FHA approved status would mean fewer clients, less business, and less income.
  • Compare-ratio: The FHA uses what is called the compare-ratio to evaluate FHA approved lenders. It is one of the key ways they assess whether a mortgage lender should keep his or her FHA lender status. The compare-ratio is when all lenders in an area are compared to each other in relation to their performance. For example, are the loans they approve paid on time or are they going into default leading to foreclosure?
  • A cycle: The compare-ratio is the starting point of the cycle of lenders and brokers raising their overlay ranges and the minimum FHA loan credit score that they see fit. One lender raises its lowest FHA credit score to reduce or lower the lender's compare-ratio. This leads other lenders and brokers in the area to do the same. They may also run the risk of no longer being approved by the FHA and being removed from the FHA loan program.

New FHA Loan Credit Score Policy Minimizes Lender Overlays

Although the compare-ratio is in place and will continue to be used, the FHA enacted a new credit score policy in 2017 to minimize lender overlays. This includes the FHA loan credit score overlay range of 620-680 set by lenders and brokers. The new 2017 FHA credit score policy brings the lowest FHA loan credit score needed and the minimum credit score required by lenders and brokers closer to the regulations and guidelines set by the FHA. This allows FHA loans for bad credit applicants to be more attainable than it was before.

The new policy does this by continuing the compare-ratio with an added evaluation step prior to removing a lender's FHA approved status. This extra step involves looking at defaulting loans and mortgages with late payments in credit brackets. The new policy uses three credit score brackets:

  • 640 or under
  • 640-680
  • 680 or above

There are three ways this new policy will help lenders and brokers alike:

  • FHA approved status: Lenders cannot lose their FHA approved status if mortgages are experiencing the same performance as others in the same credit bracket.
  • Comparison area: Instead of comparing FHA approved lenders locally, lenders and brokers will be compared throughout the nation.
  • Reduced overlays: With the new FHA loan credit score policy, lenders can reduce their overlays, and reach more people who wish to become homeowners—without so much fear over having their FHA approved status revoked.

How to Improve Your Score to Meet FHA Credit Requirements

If you have your credit score pulled and it does not meet the lowest credit score needed for an FHA loan, or you would like to improve your credit score so that you can qualify for an FHA loan with a 3.5% down payment instead of 10%, consider the following:

  • Pay down your debts to lower your DTI: Paying down the balances on loans and other debts that you have will reduce the percentage of your overall debt. This will go a long way in improving your credit. Just be sure not to use the credit you are reducing and paying down. Just because it is there, does not mean you should spend it.
  • Avoid being an authorized user on others credit cards: If you are included as an authorized user to someone else's credit card, this will impact your DTI. The monthly minimum payments on that credit card become a shared responsibility between you and the card holder. If the cardholder isn't consistently paying down the balance, this will affect your credit along with theirs. Either help the cardholder pay down the balance or ask them to remove you as an authorized user.
  • Pay on time: Paying on time for the accounts on your credit report will raise your credit score. Three ways to ensure you are always on time are autopay, electronic reminders, and utilizing a calendar for payments.

While the FHA is working towards making FHA loans for bad credit applicants more accessible, lenders may take a little more time adopting the new FHA guidelines. If you believe that you don't have the FHA loan credit score that lenders have set, don't walk away from your loan search. Compare various lenders until you find one that's eager to work with you. Otherwise, take some time to improve your credit score so that it meets lenders' FHA credit requirements.

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