A credit dispute can derail your FHA applicationby Michele Lerner
Loan applicants with ongoing credit disputes will have a tougher time earning mortgage approval now that the Federal Housing Administration (FHA) has introduced a new rule about collections accounts. Beginning April 1, prospective FHA borrowers with credit disputes that total more than $1,000 will be denied FHA loan approval unless they meet a new standard.
According to the new rule, borrowers have two options for handling any disputed amount above $1,000:
- Pay off the outstanding balance in full
- Document a payment arrangement that can be submitted to FHA. The payments must be included in the borrower’s debt-to-income ratio
Credit disputes from more than two years prior to the loan application are not included in the new rule. Credit disputes related to identity theft or unauthorized users are also excluded, but borrowers must document a police report or an identity theft report from the creditor on any fraudulent charges that appear on their credit report.
Preapproval first, shop second
“This new FHA rule gives borrowers all the more reason to get preapproved for a mortgage loan before they start shopping for a home,” says Gail Kullman, a senior loan officer with Prime Lending in Alexandria, Va.
“It may take time to gather the documentation from a creditor or the police department if you are an identity theft victim. If you have to make a payment arrangement with a creditor, that can take time, too. Some lenders may want to wait until you have made three payments under the arrangement so you can show that the arrangement is working.”
Kullman says borrowers have always needed to make payment arrangements for court-ordered judgments before a mortgage loan can be approved, either by payment in full or with at least three payments documented. Lenders have varied rules about collections accounts that have not resulted in a legal judgment.
“FHA has always been more lenient than conventional financing and so not all outstanding collections had to be paid before a loan could be approved,” says Kullman. “Now [the] FHA is coming closer to conventional financing by simply requiring people to pay their outstanding collection accounts.”
The FHA has been tightening its standards in recent years to compensate for rising mortgage delinquencies that have reduced the size of their reserve fund. For example, borrowers with a credit score below 580 must make a down payment of at least 10 percent rather than the 3.5 percent required of borrowers with higher credit scores. FHA insurance premiums have also been increased in order to bolster the fund..
According to HousingWire, the tighter rule on credit disputes is a result of FHA research showing a higher rate of mortgage delinquencies associated with borrowers with unpaid collections and unresolved credit disputes.
“The original intent of the FHA program was to help first time buyers become homeowners with a low down payment and a generous gift allowance, but then the program became a substitute mortgage program for borrowers with credit issues,” says Kullman. “If a borrower has a lot of issues with collections and credit disputes, they may not be a good credit risk anyway. People with collections generally don’t have a good enough credit score to qualify for a mortgage anyway.”
Kullman says that the new FHA rule on credit disputes could prevent some borrowers from qualifying for a mortgage.
“A lot of FHA borrowers are interested in that program because they don’t have a lot of money in the bank,” says Kullman. “If they have to pay off their collections in full they may not have enough cash leftover for the down payment. If they have to arrange a repayment program, the extra payments may be enough to disqualify them based on their debt-to-income ratio.”
Borrowers who are unable to meet FHA requirements for credit disputes are unlikely to qualify for conventional financing, which generally has stricter requirements. If the borrowers are unable to make a down payment of at least 20 percent, then they will also need to meet the credit requirements of mortgage insurance companies which are sometimes stricter than the lender’s requirements.
While it remains to be seen how many borrowers will be impacted by this new FHA rule, one real estate attorney told HousingWire he expects anywhere from a 33 percent to 50 percent reduction in FHA originations this year because of the new rule .