Ideally, you only need a minimum FICO score of 500 to qualify for an FHA loan. You need at least 580 to qualify for the 3.5 percent down payment. This makes an FHA loan an ideal option for borrowers with:
- low or damaged credit
- low income
- have various income from different sources
- co-borrowers who will not stay in the house
- receive a down payment gift money but lacks down payment from their own sources
- homes that need repair
However, lenders don’t strictly follow the FHA guidelines. Even if it is not required by the FHA to pull out your credit for evaluation, many still do, and would approve only those who have a credit score of at least 620 to 640. Why is this so?
This is because of what is known among FHA lenders as the “compare ratio.”
A means of comparing lenders
The FHA takes a lender’s power to offer an FHA loan if it has a 150 percent more of late-paying loans or default compared to those lenders in other areas. To prevent this, many lenders raise their minimum credit score requirement so they can be more certain that their borrowers will not default on their loans.
As an effect, many borrowers who were supposed to be eligible for the FHA loan are locked out of approval because of this credit score requirement. Ironically, the compare ratio became a counterproductive measure to the core aim of an FHA loan.
And (at last!) the FHA realized this.
2017 FHA policy update, credit problem fixes
That is why in its latest 2017 Policy Update, the Federal Housing Administration revamped their compare ratio policy. This update does not eradicate the compare ratio strategy at all but it modifies it in such a way that the lenders will be measured in tiers. That is, the percentage of defaults are counted via the range of score that they belong to.
To demonstrate this, let’s look at the example of Lender A who loans money to 50 borrowers with credit scores between the range of 500-620. From the 50, four fails to turn in their payments after some time. In this case, Lender A already has an 8 percent bad loan rating.
Then here comes Lender B who gives out loans in the same area as Lender A. Only that this lender chooses to approve only loans to another 50 borrowers who have credit scores of 640 and above. From his 50 borrowers, two defaulted. That gives Lender B a bad loan rating of 4 percent.
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Using the original compare ratio measure, it looks like Lender A is the disadvantaged lender. Any person with common sense can say this is unfair as it does not take into account the nature of the loans which determines the risk involved.
Under the updated policy, the FHA does a comparison of its default rate against the national average for those loans carrying credit scores below 640, and not the area or region per se. This resolves the issue of fairness among lenders, and helps borrowers with low scores still get the loan they need.
With this fix, lenders will hopefully be more open to give leeways to borrowers in need and restructure their loan guidelines so that the primary goal of an FHA loan will be realized.
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