FHA borrowers will soon need a 580 FICO score in order purchase a home with the minimum 3.5 percent downpayment, and won’t qualify for the program at all if they have a score below 500.

Federal housing officials are moving closer to implementing several policy changes announced in January that will also reduce the maximum allowable seller concession on FHA-backed loans from 6 percent to 3 percent and tighten underwriting standards for manually underwritten loans.

The Department of Housing and Urban Development (HUD) on Thursday published a notice in the Federal Register outlining the details of the policy changes and the rationale behind them. HUD will consider public comments submitted by Aug. 16 before publishing a final notice that will include the implementation date for the changes.

The policy changes are aimed at curbing losses that have drained FHA’s Mutual Mortgage Insurance Fund, bringing its capital ratio below Congressionally mandated minimums.

Other steps previously taken to stem losses during the downturn include a ban on seller-financed downpayment assistance, tightening of underwriting guidelines for streamline and cash-out refinance products, changes to appraisal standards, and increased oversight of lenders.

"Given the importance of maintaining a viable MMIF for existing and future homeowners, it is FHA’s intent to focus only on particular practices that have been found to result in extremely poor mortgage loan performance," HUD said of the latest proposed changes.

The nation’s largest lenders introduced a minimum FICO score of 580 during the first quarter of 2008, across all types of financing and regardless of loan-to-value ratio, HUD said. Large lenders raised their minimum FICO scores again, to 620, in the first quarter of 2009.

The Federal Housign Administration didn’t have its own minimum FICO score requirements until July 2008, when it began requiring that borrowers with credit scores below 500 make downpayments of at least 10 percent.

Now FHA wants to require 10 percent downpayments for borrowers with FICO scores between 500-579, instead of the 3.5 percent minimum. Borrowers with credit scores of less than 500 would be excluded from the program altogether.

HUD is proposing an exemption for refinancings through 2012 that would allow troubled borrowers with credit scores between 500-579 to refinance into a high-LTV FHA loan in cases where lenders agree to forgive principal on their original loan.

Borrowers with credit scores below 580 making down payments of less than 10 percent "struggle to make their mortgage payments and ultimately lose their homes at a rate that is unacceptable to FHA," HUD said.

During the last five years, the serious delinquency rate for FHA borrowers with credit scores below 580 and loan-to-value ratios greater than 90 percent is 29.8 percent, compared to 9.29 percent of all FHA loans, HUD said.

The National Association of Realtors questioned the changes to the credit score and downpayment requirements at a Congressional Hearing in March. Credit scores are not a perfect indicator of risk, the Realtor trade group said, and the move could have a disparate impact on minorities, "(flying) in the face of the mission of FHA to serve underserved markets."

FHA insured close to 30 percent of purchase mortgages in 2009, including more than half of the loans taken out by first-time homeowners.

But because lenders have already tightened their standards, only about 1.5 percent of mortgages insured by FHA in 2009 would have been excluded under the proposed credit-score requirements, FHA Commissioner David Stevens said in his prepared hearing testimony.

NAR has also questioned the wisdom of reducing maximum allowable seller-paid concessions from 6 percent to 3 percent, saying the concessions are critical for borrowers in states with high closing costs, including Texas, New York and Florida.

HUD said allowing sellers to pay up to 6 percent of the home’s sales price to offset a buyer’s costs exposes the FHA to excess risk by potentially driving up the cost of the home beyond its appraised value.

Claim rates on FHA loans where borrowers were granted concessions of more than 3 percent have been nearly twice as great as those in which no concessions were made.

Conventional mortgage lenders have already capped seller concessions at 3 percent of the sales price on loans with similar loan-to-value ratios, HUD noted (loans guaranteed by the Department of Veterans Affairs cap seller concessions at 4 percent of the sales price).

The change will bring FHA into conformity with industry standards and reduce the likelihood of default by ensuring that borrowers have additional equity in their homes, HUD said.

In practice, HUD said seller concessions above 3 percent will still be allowed, but concessions that exceed the proposed 3 percent cap would have to result in a dollar-for-dollar reduction in the sales price for the purpose of calculating the maximum FHA loan amount.

The third change proposed by HUD will apply when mortgage lenders manually underwrite loans, as they must do for borrowers with limited or "nontraditional" credit history.

When underwriting loans manually, lenders will be required to consider factors such as debt-to income ratio and cash reserves.

Borrowers who require manual underwriting will be required to have minimum cash reserves equal to one monthly mortgage payment, including taxes and insurance, and maximum housing and debt-to-income ratios will be set at 31 percent and 43 percent, respectively.

Borrowers with credit scores of 620 or higher may qualify for housing and debt-to-income ratios of up to 37 percent and 47 percent, respectively, if they can show "compensating factors" such as a year of timely payments of their rent or mortgage, and additional income or reserves.

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