Wells Fargo has dramatically lowered credit score requirements for Federal Housing Administration (FHA) mortgages, the first major lender to do so following pressure from the agency and housing advocates.

Last month, Wells began accepting applications in its retail branches for FHA loans from borrowers with FICO scores as low as 500. Previously, it required a score of at least 600 for retail FHA borrowers. The minimum FICO score remains 640 at the company's wholesale and correspondent channels.

Although the move could open the spigot for a number of homebuyers with bad credit, it's not a free-for-all. For borrowers with the lowest credit scores, Wells has added other major restrictions, including a minimum 10% down payment and a maximum 31% monthly mortgage debt-to-income ratio, that are expected to reduce the number of consumers who would qualify. Borrowers with credit scores of 580 to 599 will need a down payment of at least 5%.

FHA Commissioner David Stevens has been urging lenders in the federal mortgage insurance program to lower their minimum credit scores. Last year he said that banks' "credit overlays" – requirements for FHA loans that are tighter than the agency's own standards – were artificially constraining home sales by as much as 20%.

Demanding a credit score of at least 640, for example, excludes about 15% of potential FHA borrowers, Stevens has said.

"Stop eliminating 10% to 20% of the market for people who are able to buy a home," Stevens told bankers at a conference in November. 

Tom Goyda, a Wells spokesman, said the bank "is committed to responsibly serving a wide range of borrowers." The new requirements, he said, "are designed to ensure we lend to customers who we believe have an ability to pay."

Overlays are meant to protect the lender against default risk. Even though FHA loans are insured by the government, it can make the lender indemnify the agency against losses if underwriting errors are discovered. Defaulted loans are also costlier for a lender to service.

The change by Wells also comes a few months after a consumer advocacy group filed a redlining complaint with the Department of Housing and Urban Development (HUD), FHA's parent agency, against 22 smaller FHA lenders.

The National Community Reinvestment Coalition said those lenders had refused to accept loan applications from borrowers with scores in the 580 to 620 range, a restriction the group said violated FHA policy. (Brian Sullivan, a HUD spokesman, said: "FHA does not require lenders to lend to our FICO requirements but we absolutely do expect them to comply with all fair housing laws. Put another way, lenders have to comply with fair lending as it relates to taking a loan application.")

Wells was one of 17 other lenders – including Bank of America Corp. and JPMorgan Chase – that agreed to meet with NCRC officials to discuss ways to comply with FHA's requirements rather than be fingered in a complaint to HUD.

By accepting lower FICO scores in the retail channel, Wells appears to have struck a winning compromise that allows big lenders to maintain credit overlays.

"If there is a legitimate business rationale for the overlay, it may be allowable under FHA parameters and may be a justification against a fair lending complaint," said David Berenbaum, NCRC's chief program officer.

Another lender, Quicken Loans, dropped its credit score overlay of 620 to 640 and adopted a minimum 580 FICO threshold last month. The lender said the old requirement reflected what the buyers of its loans would accept.

"The fact that lenders are reengaging in this shows that it can be a gray area," said Bill Banfield, Quicken's vice president of capital markets. "I don't think FHA has said ‘you must do something,' but they're encouraging lenders to make smart decisions. Things evolve over time and you look for opportunities where you could do loans for people that may have a blip on their credit but can prove they have the ability to repay."

Some lenders suggested that Wells is using the lower FICO requirement as a loss leader to drum up business from real estate agents and homebuyers at a time when the home purchase and refinance markets have ground to a halt.

"Realtors are now calling them with every dead deal on their docket," said Brian Koss, managing partner of the Danvers, Mass., lender Mortgage Network Inc.

He said Wells' strategy could backfire because loan officers now have to sift through thousands of loan applications from borrowers with bad credit, trying to find a few gems that could meet the otherwise-strict underwriting requirements.

Banfield at Quicken said: "Hopefully we're catching people on the way up the FICO ladder and not on the way down."

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