Why Are Some Lenders’ Guidelines More Restrictive than FHA Requires?

by Gina Pogol
March 22nd, 2010

If you’re shopping for an FHA mortgage and have some credit issues, you may have come upon a curious discrepancy. FHA states that it will soon impose a minimum 580 credit score for those who want to put only 3.5% down or refinance with only 3.5% home equity. Yet many lenders are requiring scores of 620 or even 640 to do an FHA loan at all. If FHA is willing to insure a mortgage with a 580 credit score, isn’t the lender protected? Why should it impose stricter requirements?

The answer lies in HUD’s stated policy, which is to terminate a lender’s approval to underwrite FHA mortgages if it has excessive defaults and claims. While lenders used to feel pretty safe approving loans as
long as they met HUD’s stated underwriting criteria, they no longer can. HUD is is even seeking to expand its legislative authority to withdraw underwriting and originating approval from an FHA lender nationwide if  the performance of its regional branches becomes suspect. And with FHA mortgages taking up about a third of the market share for all home loans, that’s a chunk of business no lender wants to lose.

HUD can withdraw its approval from any lender that has a high percentage of defaults even if those loans were originated in accordance with FHA mortgage guidelines. One tool that HUD uses to determine if a lender has “excessive” defaults is what it calls a “compare ratio.” The default ratio of a lender is compared to that of all lenders in its region. For example, if 4% of all mortgages in California are in default, but a lender in Fresno has an 8% default rate, its “compare ratio” is 200%. And 200% is high enough to get its approval yanked.

This is especially interesting given that credit scores are not the stellar foreclosure predictors they were thought to be. People with prime mortgages and good credit are today defaulting in droves, and a big determining factor is the extent to which they are underwater on their loans. Once property values drop to less than 75% of what is owed on the property, the propensity to default increases dramatically — for all credit profiles. In fact, a New York Times article reported that, for the first time, borrowers with high credit scores were more likely to skip their mortgage payments than their credit card payments.

However, HUD has a mission to enhance home ownership among the less privileged, who often also have lower credit scores, so it’s reluctant to restrict access to mortgage funds among the less fortunate. But lenders who have to protect their business are understandably less politically correct.

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