Your eligibility for an FHA loan depends on your qualifying ratios. Just what are they and how do you check them? We’ll discuss them in detail below. One thing you should know upfront, though, is the FHA has lenient guidelines. They have higher maximum ratios and allow for certain compensating factors to help you qualify for the loan.
The Qualifying Ratio Requirements
The qualifying ratios the FHA concerns themselves with is the debt ratios. This is the amount of your debts compared to your income. They look at your debts two different ways:
- Front-end ratios – This is your total housing payment compared to your gross monthly income. Your housing payment is more than the principal and interest. You must also include real estate taxes and homeowner’s insurance. Additionally, you’ll add your monthly mortgage insurance. This total shouldn’t exceed 31% of your gross monthly income.
- Back-end ratios – This is your total monthly debts compared to your gross monthly income. Total monthly debts equal the above housing payment plus any other monthly payments. You don’t have to include things like groceries or utilities. The FHA includes installment loans, credit cards, and any federal debt with a payment plan. This ratio shouldn’t exceed 43% of your income.
If you have ratios slightly exceeding these amounts, you may still secure a loan. But you must have compensating factors in place. We’ll discuss the compensating factors next.
Compensating Factors you Can Use
Compensating factors help you make up for a negative aspect of your loan. In this case, we focus on debt ratios. Let’s say you have a front-end ratio of 32%. You’ve done all the negotiating you can to get the payment down. This is as low as it will go. A lender may grant you an exception if you can provide one or more of the following:
- High credit score – The FHA requires a credit score of at least 580. What a lender considers “high” is relative. One lender might expect a score over 700 for you to use it as a compensating factor. Others may accept a score around 680.
- Reserves on hand – Any money left after making your down payment and paying closing costs can be used for reserves. Basically, it’s liquid assets you have on hand. Lenders count the reserves based on the number of mortgage payments it covers. For example, if you have $6,000 and your mortgage payment is $1,000, you have 6 months of reserves. The more reserves you have the better.
- Stable income – Employers prefer a borrower with a stable income. Even if you changed jobs over the years, they want increasing income. If you changed jobs and your income decreased, it’s a risk for the lender. Showing consistently increasing income, however, may count as a compensating factor.
Figuring Out Your Ratios
Before you even apply for a mortgage, you can figure out your own debt ratios. First, you must determine your gross monthly income as the lender sees it. This is different from the amount you take home. The gross monthly income is the money you make before taxes. Salaried employees can take their annual salary amount and divide it by 12 months. This leaves them with their gross monthly income.
If you are an hourly, commission, or employee paid any other way, you’ll need your W-2s or tax returns for the last 2 years. You’ll take the total income for 2 years and divide it by 24 months. This gives you your average monthly income for qualification purposes.
Once you know your monthly income, you can determine your qualifying ratios. You’ll need your proposed mortgage payment and total monthly debts.
Housing ratio = Proposed mortgage payment/Gross monthly income
Back-end ratio = Total monthly debts/Gross monthly income
As we stated above, it’s best if the ratios are around 31/43. If they are higher, you may find a lender willing to grant an exception. Because each lender has their own requirements, you may find some lenders unwilling. Just keep shopping with different lenders until you find one willing to give you a loan.
Other Requirements for the FHA Loan
Aside from the qualifying ratios, there are other requirements you must meet for the FHA loan.
- You need a credit score of at least 580 for a down payment of 3.5%. If you have a credit score lower than 580, but higher than 500, you can put down 10% and qualify. This is on a lender-by-lender basis, though.
- You should have a 2-year employment history with the same employer. If you changed jobs within the same industry, the lender may grant an exception. Also, if you went to school or obtained training for a new position, it may be acceptable.
- You should be at least 2 years out from a bankruptcy and 3 years out from a foreclosure.
- You should have enough money for the 3.5% down payment plus closing costs. If you don’t, you may get gift funds from family members or close friends. In some cases, the seller may help with the closing costs too.
The FHA loan offers lenient guidelines. Again, it depends on the chosen lender. Some lenders add many more requirements onto what the FHA requires. Others stick with the FHA’s guidelines alone. It depends on their threshold for risk. It also depends on your other qualifying factors.
Qualifying ratios are just a small part of the approval process. If your ratios fall into line and your credit score is “decent” you should have a chance at getting an FHA loan. Keep in mind, you’ll pay mortgage insurance for the life of the loan. This means 0.85% of the average outstanding balance. Your lender will charge it to you on a monthly basis to make the insurance more affordable. It’s not an insurance you can eliminate down the road though. As a tradeoff, though, the FHA loan is lenient and a great way to purchase the home you always wanted.