FHA Loans - For Bad Credit- Not So!

I have been reading lately in different places that FHA Loans Are For Bad Credit individuals. I am here to tell you- this is not true and has never been true. I do not know where this all started but someone is misinformed and I will explain. Yes, the guidelines are less stringent than conventional loans to "some" degree, but it does not constitute saying that FHA allows "bad credit."

Bad Credit Defined:

Bad credit is when an individual(s) has a total disregard for paying their credit obligations for one reason or the other. It means that there can be lots of 30 day late payments, installment, revolving and open end accounts and including mortgage payments (if applicable). It can mean that the client also has delinquent tax liens, garnishments, collections, charge offs, judgments, bankruptcy, delinquent child support payments and possibly garnishments.

FHA of course does not make the loans; they work in a partnership with the lenders. They insure part of the mortgage loan. The lender supplies the money and makes the loan.

FHA (Federal Housing Association) makes the rules and regulations and never has there been a time that they have allowed "Bad Credit Loans."

The FHA was originated for the low to moderate income individuals so that all neighborhoods could participate in home-ownership. Their guidelines will allow some things that are unlike the conventional underwriting guidelines; but not "bad credit."

Listed is some of the guidelines for FHA Loans

As with any mortgage loan including VA, FHA loans are automatically run through an automated underwriting system that has been approved by the Federal Housing Association. This system weighs the risk process and spits out a recommendation. If the recommendation is negative; the loan can still be underwritten manually. FHA has become more conservative due the high default rates of mortgages within the past 2 years. They are becoming more and more conservative as FHA has been closing the bulk of the loans for some time now.

A credit report is pulled and is called a tri-merged credit report. It should have three (3) scores, just like for conventional loans. Sometimes there are only two (2) and sometimes only one, (1). On occasions in a manual underwriting case, the lender will verify non-traditional credit so that there will be sufficient trade lines to evaluate the borrower's ability to repay the debt. These non-traditional credit references are usually, rent, phone bills, utilities etc. A 12 month history is obtained and then used as the borrower's credit references.

The FHA loan is evaluated in this manner:

It is called the four (4) C's. Credit, Capacity to repay the loan, cash to close and the collateral. Still nothing says that you can have "bad credit."

FHA analyzing of credit is:

• past credit performance
• analyzing credit history
• documenting analysis of delinquent accounts
• developing credit history
• documentation non-traditional credit providers

When the credit report is reviewed, it is reviewed to determine if the borrower has paid their obligations in a timely manner to date, and shown a regard for meeting their credit responsibilities as agreed to from the history shown on the credit report or the non-traditional accounts (if applicable). If they have occasionally had minor credit issues which are isolated, and can back up with an explanation; but have been current with the majority of their trade lines within the past 24 months, this is reviewed to see if there is a pattern of non payment. If not and if there are only minor issues, such as a medical collection, a small charge off amount (which sometimes occurs without knowing) or paid tax liens (notice I said paid); this will not disqualify the client from getting their loan if all the other stipulations are met.

On the one hand, a past financial difficulty (loss of job, decreased income, death in the family, medical bills, sickness etc., occurred) but they have since that time maintained their credit without delinquency for a reasonable time period; this does not disqualify the client. But, on the other hand, if there appear to be a total disregard for their credit obligations, meaning 30, 60 or 90 day late payments within the past 24 months; which are excessive with other derogatory information reported; the loan will be declined. The key is a history. Bad things happen to all of us, sometimes but when an underwriter looks at the credit report, they can usually make a very good call on someones intentions to repay their credit obligations as they have agreed to do.

For instance: when a client has trouble paying all accounts on their credit report, something is wrong. If they cannot pay a car installment loan, a personal loan, or a revolving loan without 30 or 60 day late or their housing rental payments; it is a clue. It is not likely they will repay a mortgage loan any differently. A one time event is different than a consistent pattern.

The basic benchmarks for evaluating credit involves the payments on:

previous housing expenses, including utilities, then payment history on installment debts, and then payment history for all revolving accounts.

Collections: if there are collection account; Any lender who approves a loan with collection accounts or judgments must justify why. The borrower must explain in writing and documentation. FHA does not always require collections (the lender may have a different guidelines than FHA, they may require the debt to be paid) to be paid off; but these issues will result in lower credit score.

Judgments: that are court ordered must be paid off at closing of the loan or before FHA will endorse the loan. This is different if a payment has been agreed upon by the creditor and the client.

Foreclosure or deed-in-lieu: the applicant is usually not considered eligible for FHA financing if one of these has occurred within the past 36 months.

Chapter 7 bankruptcy; the chapter 7 does not disqualify the client if at least two (2) years has lapsed since the date of the discharge of the bankruptcy. There must be sufficient re-established good credit or the client has chosen not to make new credit obligations.

If the client can show (document; divorce etc.) that the bankruptcy was caused by extenuating circumstances beyond his/her control and has since that time demonstrated the ability to manage his/her financial responsibilities in a timely manner; less than 2 years may be acceptable, but not less than 12 months.

Chapter 13 bankruptcy: This does not disqualify the client from obtaining a mortgage if the following applies: at least one year of the chapter 13 has been paid and the payment have been paid without any delinquent payments.

There must be a written letter from the court for the borrower to be allowed to enter into new debt. **These cases more than likely will require a manual underwriter and a proven ability that this is not likely to happen again.

As you can now see, FHA allows for extenuating circumstances in some cases and gives ways to build credit, when there is no credit.  The client's history is still evaluated and it must be determined that the borrower is a satisfactory credit risk. 

There is never a loan made where a disregard for credit obligations are ignored.

These issues are benchmarks, but are real ones; every case is evaluated a little differently as all people are not the same.   A Chapter 13 indicates that the borrower has a desire to repay the debt and that is why FHA allows a loan after one full year of successfully paying their debt. They cannot have other delinquent issues of new debt that would only proven and unsuccessful attempt to repay their debt.

Not any of these issues indicate "Bad Credit." If there is "Bad Credit," the loan will not be approved. Any client can have issues on their credit report they do not know about and these issues must be cleared up before a loan can be approved.