FHA mortgage programs are the most lenient in the industry and borrowers with low credit scores have frequently had no other options except FHA financing.
Current FHA guidelines state that borrowers with credit scores above 580 are qualified for FHA financing with only a 3.5% down payment. The reality, however, is quite different as very few borrowers with credit scores below 620 are being approved for an FHA mortgage. This is a radical departure from previous lending policies. As recently as 2007, FHA borrowers with credit scores below 620 constituted almost half of all FHA loans approved. As can be seen below, the current number of FHA borrowers with credit scores below 620 is only 3%.
As residential property markets started to collapse in 2007, lenders were flooded with delinquencies and defaults and lenders started to significantly tighten underwriting guidelines. Borrowers with credit scores below 620 were viewed as subprime borrowers, likely to wind up defaulting on their mortgages.
Despite the credit guidelines established by the FHA, banks are not required to consider borrowers with credit histories viewed as substandard. All major FHA lenders have “credit overlays” under which they establish their own set of underwriting guidelines which frequently exclude borrowers with FICO scores below 620.
In a recent “white paper” from the Federal Reserve, Chairman Ben Bernanke made the following points about mortgage credit conditions and explained why banks are refusing to lend to borrowers with sub 620 FICO scores.
- In the recent past, mortgage lending standards were very lax and some tightening in underwriting guidelines was “necessary and appropriate.”
- The current imposition of very tight standards for mortgage borrowers is preventing lending to customers that are credit worthy.
- Besides the requirement of higher minimum credit scores, lenders can restrict credit in a variety of other ways, including higher fees, higher interest rates, larger down payments, more rigorous appraisal standards and offering fewer mortgage products.
- The tightening in credit standards that began in 2007 has not been reversed and banks are reluctant to lend, even for prime mortgages that are eligible for FHA guarantees and on which the lender does not have credit risk.
- Less than half of lenders offer mortgages to borrowers with FICO scores below 620, even if the borrower makes a 10% down payment.
- Lenders have tightened credit standards due to concerns about the high costs of loan servicing if the borrower defaults and foreclosure is necessary. Lenders also want to avoid the high costs and risk associated with being forced by the FHA or GSEs to repurchase a defaulted loan. The risk of having to repurchase defaulting loans obviously discourages the origination of new mortgages with low credit scores.
- There has been a large decline in home purchases by first time borrowers who face restricted credit standards. In addition, consumers are avoiding a home purchase due to economic uncertainty, falling home values and declining incomes.
The housing and mortgage markets are obviously broken and there is no magic cure from either the Federal Reserve or Congress. Ultimately, as the economy improves, so too will the housing market. On the bright side, first time home buyers now enjoy much more favorable pricing as home prices in many parts of the country have dropped back to levels last seen in 2000.