DTI Ratios and Credit Report Analysis [FHA vs Conventional Financing]
This ARTICLE About DTI Ratios And Credit Report Analysis For FHA Vs Conventional Financing Was PUBLISHED on July 29th, 2019
Conventional Loans have more strict underwriting standards than FHA loans; specifically when it comes to Debt-to-Income (DTI) ratios and Credit Report Analysis (e.g. trade lines, collections, charge-offs, evictions, repossessions, bankruptcies, foreclosures, etc.)
- Borrowers only need a 580 FICO score to qualify for 96.5% FHA mortgage financing (e.g. 3.5% down payment)
- To qualify for most 95% conventional programs a borrower must have a minimum 620 FICO (e.g. putting down 5% requires a 620 score).
- 1st time purchasers with higher FICO scores may be eligible for 97% conventional financing if they are below a certain household income limit (e.g. First time buyers with good credit can buy with only 3% down.)
- To be considered a first time home buyer you must not have purchased a house in the last 3 years.
- Most buyers and current home owners believe that FHA financing is only for borrowers with poor credit or for those who don’t earn enough money
- This is a false assumption
- There are certain occasions where a borrower with strong credit and high income may benefit from FHA home loan financing versus a Conventional Loan
Buying a Multi-Family Home [2 to 4 Unit]
One situation where a purchaser would benefit going FHA versus Conventional would be if they are buying a multi-family home and plan to occupy one of the units.
- Multi-unit homes can be categorized as “residential” if they do not exceed 4 units
- Borrowers applying for multi-family financing are potentially eligible for residential applications
- FHA financing permits Loan-to-Value ratios up to 96.5% for multi-unit homes which means a qualified buyer may only need to bring 3.5% to the table
- Conventional mortgage loan financing on the other hand is maxed out at 95% of the purchase price for single-family dwellings but get choked down even further for multi-unit homes
- Conventional loans are maxed out at 85% Loan-to-Value Ratio for multi-unit properties (e.g. buyer must come to the closing table with 15% down)
- Both of the Government Sponsored Enterprises that invest in conventional mortgage loans require this higher down payment amount to offset risk
- Similarly to 2 unit homes, 3 to 4 unit dwellings are also capped at 85% LTV ratio by Fannie Mae and Freddie Mac (Government Sponsored Enterprises)
The situation above outlines a scenario in which a borrower with higher-than-average income and a strong credit profile may realize a greater benefit with FHA mortgage loan financing as compared to Conventional Loan financing.
Updated Debt-to-Income (DTI) And Credit Analysis Guides [FHA vs Conventional Financing]
New underwriting requirements have emerged over the last 12 months with regards to Debt-to-Income Ratio and Credit Report Analysis
- Debt-to-Income ratio caps have been increased within the conventional loan investors’ Automated Underwriting System (AKA Fannie Mae’s Desktop Underwriter and Freddie Mac’s Loan Product Advisor)
- Both of these AUS systems now allow DTI ratios up to 50%
- However, it is still very difficult to receive an approved status inside the AUS with a minimum 620 FICO and a maximum 50% DTI ratio
- A combination of low FICO scores and high debt-to-income ratios indicates excessive risk and will most often result in an “ineligible” or “refer” status
- Condos have been attributed a greater risk classification compared to single family dwellings and they now carry larger LLPAs (e.g. pricing adjustments that negatively affect the interest rate)
Updates have been released for both FHA and Conventional financing programs with regards to Credit Report Analysis and Debt-to-Income Ratios
The updated 2019 requirements are as follows:
- The maximum financing amount, with the exception of multi-unit dwellings and high cost areas, was reduced from $410,000 to $271,000 a few years ago
- The Department of Housing and Urban Development later enacted another increase up to $314,827 due to economic recovery and an improvement in housing values
- The cap on FHA loan amounts can present an obstacle for buyers who are in the market for higher-cost houses
- Shoppers who are seeking a larger home with a purchase price and/or mortgage loan amount that exceeds FHA’s loan limits must utilize conventional loan financing for their purchase
- Anyone in the market for a bigger, higher-cost house has to do so via conventional financing
- 580 minimum qualifying score with 96.5% FHA financing
- 90% maximum financing for borrowers with qualifying scores less than 580 (e.g. borrowers with distressed credit may still be eligible but they’ll need to bring 10% down to the closing table)
- Borrowers with high DTI ratios who are finding it difficult to get approved can use a family member as a non-occupying co-borrower to help reduce the ratio (e.g. add more qualifying income to the file).
- Borrowers with a minimum qualifying score of 620 cannot exceed a 43% debt-to-income ratio
- Borrowers with a qualifying score greater than 620 may be eligible to close on a mortgage with a DTI ratio up to 55%.
The maximum mortgage loan amount for Conventional Financing was raised in 2019 up to $484,350
Mortgage Lending Requirements For Collections
Updated guidelines have been released by secondary-market mortgage investors with regards to collections:
- Accounts in collection with an aggregate balance due that is greater than $2,000:
- If borrower cannot pay off balance in full prior to closing then 5% of the total balance due must be included in the DTI ratio
- As an example: if an applicant has an aged $1,200 cell phone collection lingering on their report then $60 will be listed as a liability on Form 1003 (aka loan application)
- Before this update borrower were required to pay all open collection balances in full
- If an applicant arranged a payment plan with the creditor to pay the delinquent balance then the underwriter will use the terms of this arrangement instead of using the 5% rule.
- Medical debts are an exception to these guidelines and do not require payoff or DTI inclusion
Mortgage Lending Requirements For Disputed Accounts On Credit Report
Stringent requirements exist in mortgage guidelines with regards to disputed accounts listed on an applicant’s credit report.
Rules and underwriting guide lines for disputed trade lines apply to all types of mortgage financing programs (e.g. Conventional, FHA, VA, and USDA)
- Applicants aren’t allowed to carry disputed accounts with an outstanding balance due
- As an example: if James wants to apply for an FHA loan to buy a home and he has a $750 Comcast bill in collection from his previous residence, he can’t simply omit the liability from his application by filing a dispute with Equifax, Transiunion or Experian.
- Filing a dispute with the goal to get an account expunged from the credit repository records will not work; the trade line will still exist on an applicant’s credit report and the mortgage loan underwriter will see it
- In most cases, a mortgage loan application cannot proceed with the existence of a disputed trade line
- Some lenders will allow the presence of disputed accounts under $1,000 aggregate balance with regards to FHA mortgage loans
- An underwriter can require an account to be “undisputed” before the application can be processed.
- It’s important to know, however, that upon removing the dispute an applicant’s FICO score may decrease
- If the FICO score decreases too much then that could cause stress on the file and potentially a denial due to insufficient credit score
- As mentioned previously, medical trade lines in dispute are not governed by these guide lines and typically do not affect qualification
- Trade lines in dispute with no balance due are also considered an exemption
- Non-medical ccounts in collection with a total balance due with an amount less than $1,000 also falls under “exemption” status
Seasoning Requirements And Waiting Period After Recent Credit Event [Foreclosure And Bankruptcy]
Recent derogatory credit events require seasoning (AKA waiting period) prior to getting approved for a mortgage loan.
Derogatory credit events most typically involve short sale, foreclosure, deed-in-lieu, and/or bankruptcy (Ch. 7 or Ch. 13).
Below is a list of common waiting periods based on type of derogatory event:
- 2-year seasoning requirement after date of discharge on Ch. 7 Bankruptcy
- 3-year seasoning requirement after recording date on Foreclosure of Deed-In-Lieu
- 3-year seasoning requirement after date of Short Sale (as indicated on the settlement paperwork)
- After the 2008 financial crisis there was an FHA guideline called “Back to Work Extenuating Circumstances” – this has been retired
- The Department of Housing and Urban Development originally released this program back in 2013 which effectively cancelled the 3-year seasoning/waiting period
- The goal of HUD’s creative program was to help stimulate the housing market by getting more credit-distressed borrowers into a home
- By all accounts this government program turned out to be a failure
- In order to be considered for the program, a borrower needed to have a strong credit profile prior to their loss of employment
- Loss of employment had to be the sole factor in why they filed bankruptcy or experienced a recent foreclosure, short sale, or deed-in-lieu
- The borrower had to have been without a job for at least 6 months or the borrower must have experienced a 20% income loss
- Borrowers needed to rehabilitate poor-performing trade lines and/or establish new positive trade lines with perfect repayment history after the bankruptcy, foreclosure, short sale, or deed-in-lieu
- Verification of rent was always required with this program
- The only way to get around VOR was to have a sufficient explanation letter that was accepted by the underwriter
- The Department of Housing and Urban Development required each applicant to take a housing counseling class to be eligible for the program
No Seasoning Or Waiting Period Required After Bankruptcy, Short Sale, Foreclosure, Deed-In-Lieu
The Back To Work program enacted by HUD turned out to be a gigantic failure and has been discontinued.
- The program for “extenuating circumstances” was cancelled in 2014
- A large number of borrowers applied for this program when it existed
- Out of all the applicants only a very small percentage ended up at the closing table
- The Collin Hoyer Team provides Non Qualifying Mortgages without any seasoning requirements.
- The only exception is a 1-year seasoning timeframe after the date of discharge on Ch.7 Bankruptcy filing
- All Non-QM programs max out at 80-90% financing (e.g. borrower must bring 10-20% to the closing table)
- Ultimately the down payment percentage is determined by the applicant’s FICO score and other factors
FHA Private Mortgage Insurance And Up Front MIP
The main reason why most people dislike FHA financing stems from monthly Private Mortgage Insurance and the required Up Front Mortgage Insurance Premium.
- The Federal Housing Administration imposes a single upfront MIP fee equal to 1.75% of the mortgage loan amount.
- FHA also charges an annual percentage based on the outstanding balance amount
- The only ways to avoid this issue is by doing one of the following:
- Refinance into a Conventional program
- Sell home and pay off the FHA home mortgage
Conventional Home Mortgage Loan
Unlike FHA’s lower FICO score requirements, conventional financing options require a 620 minimum qualifying score.
- Although a 620 score may be considered relatively decent by many people, it is actually considered a terrible score with regards to conventional underwriting guides and interest rate pricing (e.g. applicants with a 620 FICO will have great difficulty getting approved for conventional financing and those who do get approved will be faced with higher interest rates).
- In order to truly realize the benefits of conventional loan financing, an applicant must have a qualifying FICO above 740.
- As opposed to FHA financing where all credit scores are treated equally with regards to rate, conventional loans vary considerably
- Conventional mortgage rate tiers are separated by 20-point segments (e.g. a 680 FICO will have a lower rate than a 660)
- To put it simply, rate adjustments exist in a ladder structure
Credit Report And Debt-to-Income Guidelines For Conventional Loan Programs
Below is a brief overview of Credit Analysis and Debt-to-Income Ratio underwriting requirements.
- 620 is the lowest qualifying FICO score
- Minimum down payment contribution brought to closing table:
- 3% down (1st time buyer)
- 5% down (condo/town house/row house)
- 10% down (second home/vacation property)
- 15% down (2-unit dwellings)
- 25% down (3-4 unit dwellings)
- Seasoning requirements:
- The seasoning requirements after a derogatory credit event is much more stringent for conventional financing as compared to FHA mortgage loans
- 7-year seasoning requirement after foreclosure
- 4-year seasoning requirement after Deed In Lieu of Foreclosure
- 4-year seasoning requirement after Short Sale
- 4-year seasoning requirement after date of discharge on Ch. 7 Bankruptcy
Situations In Which Conventional Financing Is The Only Available Choice
There are certain scenarios in which conventional financing is the only choice (AKA FHA mortgage can’t be used for this).
- If a borrower is looking to buy a condo and it isn’t on FHA’s Approved Condominium List then the only choice is to buy it using conventional loan financing
- Another example is if a borrower wants to purchase a vacation home or rental property. FHA does not allow transactions involving these types of property.
- The Federal Housing Administration only permits the financing of primary residences that will be occupied by the purchaser.
- A borrower must utilize conventional mortgage loan financing to buy a vacation home or investment property.