For individuals navigating homeownership for the first time, conventional loans may seem out of reach due to high credit standards and stringent requirements. Fortunately, FHA loans are a great option for borrowers with lower credit scores or limited funds for a down payment.
FHA loans, which are backed by the Federal Housing Authority, give lenders added assurance that the mortgage loan will be profitable. This in turn encourages lenders to offer financing to a wider range of individuals who might otherwise be denied traditional mortgage loans.
Although FHA loans have flexible terms, there are still some minimum credit standards that borrowers must meet in order to be approved. Since credit is one of the biggest factors that lenders review during the approval process, borrowers should understand the FHA credit requirements and work to get their credit in order before applying for a loan.
How FHA Credit Requirements Are Determined
Before approving a loan, lenders need to evaluate the risk associated with the transaction. If the borrower’s ability to repay the loan is questionable, the lender will do one of two things: add a premium in the form of higher interest rates to ensure they will recoup as much of the loan as possible in the early repayment years or deny the loan altogether if the borrower’s ability to repay is deemed too risky.
Individual lenders have the flexibility to set their own credit standards for issuing FHA loans, as long as they meet the FHA-issued minimums. Since mortgage loans are usually issued anywhere from 15-30 years, some lenders may look for higher credit scores to improve the odds of full repayment.
FHA Minimum Credit Score
The lowest possible FICO® credit score a borrower can have to obtain an FHA loan is 500. However, loans issued to borrowers with scores below 580 are considered “subprime” and come with some additional drawbacks.
Borrowers with scores between 500-579 should be prepared to have a larger down payment amount of 10%, a lengthier underwriting process with additional supporting documentation required and a higher interest rate assigned to the loan.
FHA Loan Benefits of a High Credit Score
While FHA loans are often recommended for borrowers with lower credit scores, borrowers with high credit scores can receive many benefits from choosing an FHA loan for their home financing. These potential benefits include:
- Wider choice of lenders: Borrowers in the “above average” credit category will be favored by various FHA lenders since they will be more likely to repay the loan.
- Smaller down payment required: With a minimum credit score of 580, borrowers can be approved with a down payment as low as 3.5%, saving a considerable amount over conventional loans that typically require 5%-20% down.
- More budget-friendly: If a borrower’s credit score is 620 or higher, lenders will often be more flexible with other qualifications on the loan, such as debt-to-income ratio.
FHA Loan With Bad or No Credit
While most lenders will be looking for credit scores of 580 or above, there is hope for borrowers with poor or no credit. Generally, FICO® scores below 580 are considered bad credit and at a higher risk for default. Fortunately, the FHA will still back loans for borrowers with credit scores as low as 500 with some special considerations. Those with bad credit should be prepared to:
- Find a lender who will manually underwrite the loan and carefully consider your entire financial position and ability to repay
- Gather three or more nontraditional credit references to support your application
- Pay a higher down payment to demonstrate your financial responsibility
If you have no established credit score at all, the FHA also provides lenders some flexibility to get your loan approved. In these cases, you must generally have another co-borrower with a higher credit score (620 or above), and your lender may also have additional requirements, such as credit references or a higher down payment.
Requirements May Vary By Lender
An FHA loan guarantee means that the FHA will work with borrowers and lenders to provide financial options if the borrower becomes unable to repay the loan in full at any point in the future. This guarantees that lenders will be repaid in some form on all loans approved through the FHA process, but lenders are still on the hook for delays and potential legal and administrative costs associated with borrowers who default. Since the lender, not the FHA, supplies the money to fund the mortgage loan, each lender will set their own qualifications and evaluation process.
Most lenders have standard requirements that align closely with the mandated FHA loan credit requirements, but some may require higher credit scores, additional documentation requirements or both. Additionally, while the FHA will guarantee loans for borrowers with scores as low as 500, most lenders will set their own extensive requirements to balance the added risk associated with subprime loans.
All lenders have the right to deny applications that do not meet their unique lending requirements, even from borrowers who would otherwise meet the minimum FHA requirements through a different lender. Some lenders will choose to only take on loans from borrowers who have 580 credit scores or above, so borrowers would do best to work toward that minimum threshold before applying.
What Can Disqualify You From an FHA Loan
Credit scores are one of the biggest concerns for both lenders and borrowers, but they aren’t the only factor that can disqualify you from an FHA loan. There are several FHA loan minimum requirements that must be met to qualify, and borrowers that are on the low end in all qualification categories may have a hard time getting approved.
The three most common reasons for getting denied for an FHA loan are poor credit, high debt-to-income ratio and insufficient funds to cover down payment or closing costs.
In order to make sure you have the best chance of getting approved, it’s helpful to speak with an FHA lender before you start looking at homes.