Consumers are having a tough time qualifying for a mortgage these days, and even a federal program designed to provide financing for low- and moderate-income borrowers is winnowing out applicants with low credit scores.

Figures compiled by the Department of Housing and Urban Development (HUD) show that the average credit score on an Federal Housing Administration (FHA)-backed single-family loan is now at 700.

Just 3.3% of FHA-insured loans originated in the third quarter went to borrowers with 580-619 credit scores. Back in 2009, nearly 20% of FHA borrowers had credit scores in the 580-619 band.
Lenders have many reasons for tightening their underwriting and credit standards: they are under heightened scrutiny because of the housing bust, secondary market buyers are slamming them with buyback requests, and there are multiple investigations into their servicing and lending practices.

At the same time, FHA officials are concerned that too many borrowers are being denied home financing because of low credit scores.

One year ago, the National Community Reinvestment Coalition (NCRC) reported that lenders are refusing to consider borrowers with low credit scores for FHA loans.

HUD guidelines allow borrowers with a minimum credit score of 580 to qualify for low-downpayment FHA-insured loans if they meet the agency's underwriting standards. But NCRC fair lending testers caught loan officers at nearly 40 banks saying they don't make FHA loans to borrowers in the 580-640 credit score band. “The decision by some banks to not follow FHA's policy is cutting off qualified borrowers from assessing credit,” John Taylor, president and chief executive of NCRC, said at the time.

NCRC challenged these banks to change their policies, which the activist group contends are often discriminatory and hurt working-class citizens who are trying to become homeowners.
Some of the 50 banks tested agreed to change their FHA credit score policies, according to NCRC spokesman Jesse Van Tol. But NCRC ended up filing complaints against 22 banks with HUD's Office of Fair Housing.

That was one year ago and the Office of Fair Housing has not taken any action yet. “All the cases are still under investigation so we have no comment,” said HUD spokeswoman Shantae Goodloe.
Most of the 22 banks sell their FHA loans to aggregators and large banks that set the underwriting standards and credit score requirements. In other words, the 22 don't have the latitude to set or change credit score policies, unless they decide to keep the loans on their balance sheets or become Ginnie Mae MBS issuers.

But the larger lenders that buy the FHA-insured loans are pursuing conservative policies in response to HUD enforcement actions and ongoing negotiations between state attorneys general and five of the biggest bank servicers.

“The government can't have it both ways,” said FHA consultant Brian Chappelle. “You can't be what the industry views as overzealous on enforcement and then expect lenders to expand their credit box and take on risks of new originations,” he said. Chappelle is a founder of Potomac Partners in Washington.

In response to NCRC's findings, then-FHA commissioner David Stevens appealed to the major FHA-approved lenders to reconsider their policies.

In a December 2010 letter, Stevens asked lenders to look beyond credit scores and “consider all the factors that determine the borrower's ability to repay the mortgage.”

He also noted that low credit scores could be caused by temporary setbacks and lenders should consider the reasons behind the credit score impairment. (Stevens is now the president and chief executive of the Mortgage Bankers Association.)

The appeal had some effect. In February, Quicken Loans lowered its minimum credit score to 580 from 620. “This change will open up credit to a significant group of people and allow them again to have access to purchase and refinance a loan,” said Quicken Loans chief economist Bob Walters.

NCRC has remained engaged and is in active negotiations with several large FHA lenders about their credit score policies, Van Tol said in an interview last month.

The NCRC spokesman noted that Chase Home Mortgage has changed its FHA credit score policies. A Chase spokesman told this publication that the changes were made in May, but declined to provide any details.

Even when the aggregators say they will consider borrowers with low credit scores, it doesn't necessarily make it easy to originate the loans. They often charge risk adjustment fees when the credit score is below 640 or 620, which increases the cost of the loan and reduces the LO's compensation unless the interest rate is pushed up.

And getting such loans approved and funded is usually a long, drawn-out affair that frustrates borrowers and loan officers alike.

Meanwhile, FHA has a monitoring system that flags lenders with high early default and claim rates. And it does not provide an incentive to make loans to borrowers with low credit scores.
Borrowers with a 580 to 620 credit score are four times more likely to default than borrowers with credit scores above 700.

The Neighborhood Watch system tracks default rates for each lender, comparing them to the average loan performance of all other lenders. If the average credit score is 700, lenders that make loans to borrowers with lower credit scores run the risk of ending up with a higher-than-average default and claim rates.

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