FHA Loans
In this guide, we will cover why FHA loans are so popular among homebuyers and how FHA loans work. Are you planning to buy a house but are worried about an outstanding collection account and what it could mean to your credit report? If so, today we will give you HUD guidelines for collection accounts, plus what all these mean for your ability to obtain a mortgage.
FHA loans still remains to be the most popular mortgage loan program for first-time homebuyers due to its lenient lending guidelines. To qualify for a 3.5% down payment home purchase FHA loan, you need a 580 credit score. HUD, the parent of FHA, insures private lenders in the event homeowners default on their FHA loans.
We will also tell you more about what you can do to increase your chances of getting approved for FHA loans despite having bad credit and lower credit scores. You can have an outstanding collection account, plus anything else you should know on the subject. So, whether you are a first-time home buyer or an experienced, read on to be better informed and ready for the next time you approach a mortgage lender.
Can You Get Approved For FHA Loans With Bad Credit?
FHA loans is hands down the best mortgage loan programs for borrowers with bad credit. HUD, the parent of FHA, created very lenient credit guidelines to promote home ownership. Before we know what HUD guidelines are on collection accounts, we must first understand what a collection account is. So, by definition, a collection account is a type of credit account that’s created when a borrower falls behind on debt payments, and the creditor gives up, thereby assigning the debt to a collection agency.
FHA loans are the most popular mortgage loan program for bad credit borrowers. If you have bad credit with large collection and charge-offs with low credit scores, there is no other loan program than an FHA loan that will get you an approve/eligible per AUS.
Upon the transfer, the collection agency now attempts to collect the debt from the borrower – so it doesn’t alleviate your obligation to pay the debt. In essence, what happens is that once the creditor decides to transfer the account as a collection account to the credit bureaus, he will close the account on his end. Now, you need to remember that this transfer will negatively impact your credit score, making it difficult for the borrower to obtain credit.
How Do Underwriters View Derogatory Credit on FHA Loans
Generally, underwriters view outstanding collection accounts as a sign of financial instability and a potential risk for loan repayment. So, they require you to pay off the collection accounts before you can be approved for an FHA mortgage. This is because these accounts are considered negative marks on your credit score, which may indicate an inability to repay the loan when granted.
Mortgage underwriters will look at the overall payment history of the borrower and see a pattern of their payment history. They will try to match what happened during the time of bad history. As long as the period of bad credit was an isolated incident, the underwriter will be good with it.
Mortgage underwriters may view specific types of collection accounts differently, such as medical collection accounts, as they view it as an unexpected expense and not necessarily an indication of financial mismanagement. Underwriters also favorably consider small collection accounts, especially if the borrower has a strong record of timely repayment.
HUD Guidelines on Collection Accounts
For starters, FHA, or Federal Housing Administration, require borrowers to pay off their outstanding collection accounts before getting approved for the mortgage. As we’ve already mentioned, this is because collections are considered a sign of financial instability, which puts your ability to repay the loan into serious question. However, certain types of collection accounts are exempted from this particular requirement.
Medical collections are often ignored by mortgage underwriters. You can have credit disputes on medical collection accounts. However, if you have a judgment on medical collections, it needs to get addressed.
Medical collections are considered separately from other collections accounts, and as per the guidelines, a borrower is not required to repay the debt to be approved. Additionally, suppose the borrower has a record of timely repayments and probably is in the process of paying the amount in the collection. In that case, the guidelines allow them to qualify for the mortgage. Also, HUD guidelines consider the amount in the collection account, where any amount less than $2000 doesn’t need to be paid for you to be approved.
HUD Guidelines on FHA Loans For Bad Credit
Even though the HUD guidelines may not require you to pay a particular collection account, the lender offering the loan might require you to pay it. This is because the lender takes up the risk by giving you the money, which means they can also have their guidelines. We will provide several ways in which the lender’s guidelines may differ from the HUD guidelines.
If you have bad credit and low credit scores and got denied for an FHA loan by one lender, make sure you meet HUD guidelines. If you meet HUD agency guidelines, then you will get approved for an FHA loan with a different lender with no overlays.
For starters, the lender might have stricter requirements, where they could ask the borrower to pay off outstanding collection accounts even though the HUD guidelines don’t require it. Also, the lender may set stricter guidelines on the types of collection accounts to be excluded from the pay-off requirement. The lender may set a higher minimum threshold for collections accounts, which one must pay off to be approved.
What Are Lender Overlays on FHA Loans
Most lenders have lender overlays on FHA loans. Overlays are higher mortgage requirements by lenders. Lenders can set higher requirements of their own because they may feel the borrower’s credit profile is too risky. For instance, while the HUD agency mortgage guidelines set lenders to use 5% of outstanding collection accounts as a hypothetical debt when calculating the debt-to-income ratio at the minimum amount of $2000, the lender may set it lower, at $1,000.
Before apply for an FHA loan with a lender, find out what kind of lender overlays the lender has. This is important for borrowers to go through the entire mortgage process and find out they do not qualify for an FHA loan due to the individual lender’s overlay.
The individual lender may require only a collection balance of $1,000 and require any account that exceeds $1,000 will have to be paid off first before a borrower can qualify for the mortgage. Each lender may also have a higher credit score requirement than the one required by HUD guidelines.
What Is The Lowest Credit Score You Can Get Approved For FHA Loans?
The minimum credit score requirement set by HUD is 500 FICO. If your credit score is lower than 580 FICO, you need a 10% down payment. To qualify for a 3.5% down payment home purchase FHA loan, you need a 580 credit score per HUD guidelines. This means that even if the borrower meets the score set by HUD but fails to meet the lender overlay set by the lender, they still don’t qualify for the loan.
Lenders can have higher lending requirements above the minimum agency mortgage guidelines of HUD which are called lender overlays. A mortgage lender can have overlays on anything from credit scores to gift funds to debt-to-income ratios.
The lender may also set a higher debt-to-income ratio than required under HUD guidelines, making it difficult for borrowers with a high amount of outstanding debt to be eligible for the loan. HUD has a general guideline on DTI, set at 31/43, meaning that the housing expense should not exceed 31%, while the total debt should exceed 43%.
Do All Lenders Have Different Requirements on FHA Loans?
What can you do to improve your chances of getting an FHA loan despite having an outstanding collection account? If you are looking to get approved for an FHA loan, there are still a few things that you can do to increase your chances. They include the following. First, you need to pay off the collection account’s outstanding amount with a pay-for-delete. You do not have to pay collections to qualify but doing a pay-for-delete will improve your credit score.
Not all lenders have the same mortgage loan requirements on FHA loans. Lender overlays are additional guidelines imposed by individual lenders. Overlays are higher lending guidelines of the lender above and beyond the minimum agency mortgage guidelines of HUD.
Provide documentation that explains to the lender the specific circumstances that led to the collection account. This is especially important if what led to the collection account is more of extenuating events and not financial mismanagement. If you have had a history of timely payments, you should also prove that to the lender. It may prove to the lender that you are financially responsible and that your situation is more of a minor setback you are working to resolve.
Does Paying Off Collections Affect Getting FHA Loan Approval?
You do not have to pay outstanding collections to qualify for FHA loans. If your collection account is not too old, you may try to negotiate a pay-for-delete. By doing so, your credit scores may go up, but it is not necessary. If you have a strong credit history, doing a pay-for-delete on a collection account may offset the negative impact of the outstanding collection.
Collection and charge-off accounts older than two years old has little to no impact on your credit scores and the 5% rule does not apply. If you have outstanding non-medical collection accounts greater than $2,000, HUD requires you to take 5% of the collection balance and use it as a hypothetical debt for debt-to-income ratio calculations. However, if the date of last activity of the collection account is longer than 2 years, this rule does not apply.
You may also want to provide the lender a copy of your credit report. A large down payment might also work in your favor as it could help mitigate the risk for the lender. Even with these steps, the lender has the final say on whether or not to approve your loan application. But taking these steps will undoubtedly boost your chances, helping you make a strong case.
How To Choose The Best Lenders For FHA Loans With No Overlays
Collection accounts can mess up a borrower’s ability to secure a mortgage in the future. But by understanding the HUD guidelines, the exceptions, and most importantly, taking the critical strides to improve your creditworthiness, you will be able to increase your chances of securing an FHA loan.
Non-QM Mortgage Brokers are mortgage brokers licensed in 48 states including Washington, DC, and Puerto Rico. We have a network of over 210 wholesale lending partners. We have a lending network of dozens of zero lender overlays wholesale mortgage lenders. The team at Non-QM Mortgage Brokers has a national reputation of being able to approve mortgage loans other lenders cannot do. Over 80% of our borrowers are folks who could not qualify at other lenders.
Remember that the lender’s guidelines may differ from the HUD guidelines, so you must talk to your lender or mortgage broker to understand their specific requirements. As a result, you can prepare and create a solid financial profile, which, in turn, will take you a step closer to realizing your home ownership dream.