When you apply for a FHA Loan, your loan officer will ask you for several documents (bank statements, pay stubs, W2s, etc.) all of which builds a complete financial picture of you. The documentation is bundled up and sent to a loan underwriter for evaluation. The job of an underwriter is to assess risk and predict a borrower’s ability to repay a loan. They also make sure that all the pieces of the puzzle fit within FHA guidelines.
Mortgages are obviously very large loans so lenders take a close look at applicants from many angles. However, understanding how mortgage underwriting works can be simplified by categorizing FHA loan requirements into three buckets: Capacity, Credit and Collateral. You may hear someone refer to these as the ‘Three Cs’.
Underwriters simply want to know: Do you have the means to repay your debts? The answer will come from the proof you provide of your employment and income and how they compare to your debts and assets.
Steady work history is better than spotty work history as you might suspect. Working for the same employer in the most recent two years is ideal but not mandatory. Being self-employed is fine but requires more documentation will likely be requested for underwriting review.
TIP: Avoid changing jobs if you plan on applying for a loan. It’s not the death knell for an application but it will create an extra hurdle and you will definitely need to supply a “good” reason for the change (like a promotion that requires a move to your company headquarters).
Income can come from several sources, but it must be verified over a two-year timeframe.
- Wages (W-2s)
- Disability, retirement, social security or public assistance income
- Can come from child support or alimony
- Self-employed borrowers will provide tax returns and/or your business balance sheet instead of W2s
- Your income should be expected to continue for at least three years
- When income fluctuates like sale commissions, overtime or bonuses, it is averaged over two years as documented in the borrower’s tax returns
- Income from part-time jobs is allowed, but also is subject to a two-year review
- Interest and dividends can be included
- VA income
- Rental income
- Trust income
Based on anti-discrimination laws and regulations, you cannot be turned down based on income from public assistance programs.
Lenders want to know all of the applicant’s liabilities in order make sure there’s ample money at the end of each month to make a mortgage payment. Underwriters don’t really drill into things like utilities, food, clothing and such. They’re interested in installment and revolving debt such as:
- Minimum monthly credit card payments
- Car payments
- Student loan payments
- Child support
Debt to Income Ratio (DTI)
Now that all the cards are on the table, two fundamental Debt to Income ratios are calculated that are historically predictive of a borrower’s ability to repay. FHA guidelines for DTI ratios change periodically. Your loan officer will have the most recent ratios at his or her fingertips. For now, we’ll explain two ratios, front and and back end using “31/43” below.
Front End Ratio (sometimes called Housing Ratio) compares your income to mortgage payments. The calculation is straightforward; divide your potential monthly mortgage payment and by your gross monthly income and then multiply by 100.
Monthly Mortgage Payment ÷ Gross Monthly Income x 100 = Front End Ratio
There are a few pieces that form the total monthly mortgage payment. Add up:
- Principal and interest portion of the anticipated monthly payment
- Property taxes
- Mortgage insurance
- Homeowner’s insurance
- HOA fees
Back End Ratio (sometimes called Total Debt Ratio) adds one more piece of the equation by factoring in your other recurring monthly debt payments (installment and revolving). Combining all monthly debt payments creates a new formula looks like this:
(Monthly Mortgage Payment + Monthly Debt Payments) ÷ Gross Monthly Income x 100 = Back End Ratio
Putting It All Together: DTI Limits
For FHA loans, the acceptable limits are 31% for the front end ratio and 43% for the back end ratio. A few paragraphs ago, we used the shorthand for this, it was “31/43”.
A quick side note: If you are seeking and FHA Energy Efficient Home (EEH) loan, the front end ratio edges up to 33%.
If you’ve demonstrated a long history of timely mortgage payments, stellar credit or significant cash reserves, a case may be made for an exception to the DTI rules. It doesn’t happen very often, but these “significant compensating factors” can sometimes be factored into the loan underwriting process. If a borrower’s ratios exceed the FHA limits, more often than not you will be looking at applying for an alternative mortgage product.
TIP: Don’t make any big purchases like a car if you are in the process or are going to apply for a loan soon; it’ll change your DTI. Also avoid buying furniture for a home you do not own yet. Keep your spending patterns within a normal range.
FHA Reserve Requirements
Reserves are funds you still have after the down payment and closing costs are paid.
A lender may impose reserve requirements — the amount of money you’ll need on hand (easy to get to, available) — to cover your mortgage payment for a given period of time. For example, a lender might want to know if you can you make your monthly mortgage payment for 6 months based purely on the assets you have parked in your savings account if you had no other income during that period.
There’s some good news here: FHA programs are lenient. Reserves are not required for single-family properties. However, there are small reserve requirements for multi-unit properties. For 1-2 unit properties, one month of reserves is required. For 3-4 unit properties, three months of reserves are required.
Let’s say you buy a $100,000 unit in a duplex. If the monthly mortgage payment (principal, interest, taxes, insurances and HOA dues) is $1,400 per month, then your reserve requirement will also be $1,400.
TIP: Don’t go moving money around (deposits) before applying for a loan. Lenders will look backward at your banking activity (via your bank statements) and will want to see how all money in your account got there. Lenders will look for sourced and seasoned funds. “Sourced” identifies where the money came from and “seasoned” means the money has been in the bank for a specified period of time.
Thus If your aunt Martha (source) transferred $10,000 to your account last month (not seasoned), it will not look good. Why? Because lenders want to know that Aunt Martha wasn’t firing money into your account on a short-term basis (or worse a short-term loan to you that you aren’t going to report as an additional debt). Be very, very careful about moving money around before applying for loan.
- Checking/savings (bank accounts)
- Investments and retirement account (brokerage)
- Existing real estate holdings
- Gifts from family applied to down payment
- Seller contributions
- Money made from illegal activity
- Sweat equity
- Cash on hand
- Unsourced and/or unseasoned funds
- Unsecured funds (e.g. credit cards)
Underwriters want to know: Do you have a track record of paying your debts?
The answer to that question is found by evaluating borrowers’ credit reports which contain a history of accounts, timely payments to those accounts and a summarizing credit score. Your credit history and corresponding score help predict whether you will make your mortgage payment on time and in full.
If you’ve had a few bumps in the road in the past, all is not lost. You may still qualify for a loan. Here are some guidelines for an imperfect track record:
- Two years since bankruptcy and re-establishment good credit
- Three years since Foreclosure or Deed In-Lieu of Foreclosure and re-establishment of good credit
- No outstanding judgments or delinquent on any federal debt (i.e. student loans, tax liens)
- Late payments on any debt are not specified by the FHA, but individual lenders will have policies, typically involving late payments within the last 12 months
FHA Credit Score Requirements
You’ll need a good (but not perfect) FICO score. As mentioned previously, FHA changes its guidelines every so often which is why it’s best to talk with a loan officer to get current FHA requirements. The example below shows how down payments change based on a borrower’s FICO score.
- Credit scores from 500 to 579 require a 10% down payment
- Credit scores at 580 or better require only 3.5% down payment
Depending upon other aspects of your financial situation (your income, cash reserves, etc.), lenders sometimes have more leeway. In other words, they will look at the whole picture of you as a borrower.
TIP: Don’t apply for a bunch of credit cards before or during your loan application. Opening new lines of credit harms your FICO Score. In fact, closing a bunch of credit accounts can impact your FICO score as well. This is the time to be overly cautious.
Lenders want to know if they will be sufficiently protected in the case of foreclosure. The two primary elements that determine the level of protection are the home equity (created when you make the down payment) and the property itself.
Down Payment / Equity
Simply put: The down payment creates owner’s equity in a home which acts as a buffer against a lender losses should a borrower default on a loan. As discussed in previous chapters, FHA loan allow a smaller down payments than conventional loans. That’s because lenders are protected by FHA-backed (and borrower paid-for) insurance when the equity is less than 20%.
Clearly, the lender needs to know what the house is worth. That is accomplished with an appraisal, a professional, third-party report of a home’s value. It’s an opinion. But a very well-informed one.
HUD sets Minimum Property Standards every home under consideration must meet. Why? Two reasons. Because the property is the loan collateral so if a borrower defaults, the lender will want to sell the house to recoup as much of the loan as possible. Secondly, the FHA provides the insurance and they don’t want to insure a dud as insuring many duds would increase the costs of overseeing the insurance pool. Simply put, a dump is obviously not worth as much.
What’s unique about the FHA process is that it combines an appraisal and inspection of the property. By the way, the appraiser must be FHA-approved.
Appraisers look ‘under the hood’ so to speak to make sure everything works.
- Properties must meet FHA standards: Safe, sanitary and structurally sound
- Properties that don’t meet FHA standards may mean that a seller will need to pay for repairs – or the borrower will pay for them at closing (with funds held in escrow until they are complete)
- Repairs must be made by contractors (not the buyers or seller)
- Check major systems like heating, appliances, foundations, etc
Appraisers produce a Uniform Residential Appraisal Report (URAR). Appraisals cost about $400 to $500 and can take a couple days. The cost can be rolled into the loan as long as the LTV remains within guidelines. Here’s the core of what you get in a URAR:
- Compares the property under consideration to three similar properties
- Establishes fair market value
Sometimes underwriters will want to know how the property will be used. In the case where part of a primary residence also includes a business purpose, there will limits. Business use is often okay as long as a maximum of 25% of total residential square footage is used for it. An example would be doggie day care.
Borrowers must be lawful residents in the U.S., have a valid Social Security number and be of legal age to sign a contract (mortgage) within his or her respective state. In most states the legal age is 18 years-old.
PUTTING IT ALL TOGETHER
Underwriters evaluate the complete financial picture (the Three Cs) of the borrower and then compares it to FHA guidelines as well as lender guidelines.
FHA and lender guidelines don’t always match up 100% because lenders are sometimes more restrictive or more forgiving based on their risk profile. When lender’s guidelines are added to FHA guidelines, this is known as an “overlay.” It’s possible for a borrower to be turned down even though their credit score falls within FHA’s guidelines.