FHA Restricts Mortgages for Consumers with Dinged Credit

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The cash-strapped Federal Housing Administration is making it harder for consumers with blemishes on their credit to get mortgages, potentially cutting the ranks of future homebuyers.

The FHA, which is part of the Department of Housing and Urban Development, raised credit standards this month to weed out borrowers who may pose a higher risk of default and those who may be trying to hide bad debts. The move is part of a broader effort to shore up FHA's dwindling reserves, which have been depleted by rising delinquencies over the past few years.

The agency says its new policy is a "prudent and reasonable" effort to manage risk and protect itself from borrowers that have taken on too much debt. But the change has met mixed reactions in the industry.

Some mortgage lenders praise the change as an attempt to curtail abuses of disputed credit accounts. Such accounts are not factored into a borrower's credit score, allowing some prospective homebuyers to artificially inflate their scores and potentially qualify for mortgages while still having unresolved debts. Borrowers who have fallen behind on debts often hire credit repair companies, which immediately contact the bureaus to dispute any defaulted accounts on the borrowers' credit records.

Other lenders, though, say the new guidelines will reduce the availability of credit to many potential homebuyers at precisely the time when the housing market needs them. Many low- and moderate-income borrowers can only afford to buy homes through the FHA, which allows down payments as low as 3.5%.

"FHA is making a move to eliminate risk that contradicts their whole mission," says Clement Ziroli Jr., president of First Mortgage Corp., an FHA lender in Ontario, Calif.

The new policy, which took effect April 1, affects prospective mortgage borrowers who have a collections action or disputed credit account of at least $1,000. The agency now requires those consumers to resolve their disputed or charged-off debts before they can qualify for an FHA loan.

Unlike disputed accounts, collections show up on credit reports and may be much harder to resolve. Lenders say many borrowers have medical debts in collections and may have to negotiate with their health insurer to clear them.

The FHA is now requiring that borrowers either pay off their debts or make a minimum of three months' payments before they can qualify for a mortgage. However, the agency made an exception for borrowers who fell behind because of "life events such as medical, death, divorce, loss of employment, etc." The new policy also exempts disputed credit or collections accounts that are more than two years old and those resulting from identity theft.

Russell Schroeder, a branch manager at Hometrust Mortgage Co. in Houston, says more than 30% of prospective FHA borrowers will be prevented from getting a mortgage.

"This rule really places the borrower at a great disadvantage," says Schroeder. "These borrowers do not have funds available to pay off collections and buy a house."

HUD spokesman Brian Sullivan says performance data shows that FHA loans with disputed credit and collections accounts over $1,000 had a higher likelihood of default.

"If you're carrying too much debt, you're inherently more at risk of future defaults," says Sullivan. "This was a policy decision on the part of the agency to manage risk, protect the fund and protect the borrower."

The change also risks shutting out qualified borrowers who are legitimately disputing collections attempts. As American Banker reported last week, banks including Bank of America have sold collections agencies the rights to sue over credit card debts that were potentially inaccurate or already repaid.

David H. Stevens, the president and CEO of the Mortgage Bankers Association and a former FHA commissioner, says he is concerned that FHA is "overly tightening credit."

"We believe FHA has to do everything to protect the risk on its balance sheet," Stevens says. "But the question is whether this sweeps in people who are victims of the recession and have paid their bills but can't get them corrected due to lack of contact with the collection agency" or creditor.

A blanket policy "may sweep in other anomalies," he says, particularly when borrowers have evidence that they have paid a debt but the defaulted account stills show up on a credit report.

"A lot of debts have actually been paid or are in proper disputes, but you can't get a hold of the collections agency because they're out of business," Stevens says.

The FHA's new restriction mirrors a requirement long held by private mortgage insurers, which insist that credit disputes of more than $1,000 be paid off at the closing of a home loan.

As part of its policy change, the FHA is requiring that borrowers either pay off their debts or make a minimum of three months' payments before they can qualify for a mortgage.

Hometrust's Schroeder says that establishing the three months' payment history with a collection agency "will be so cumbersome that borrowers will just give up."

Lenders say many borrowers will have trouble resolving collections accounts that are medical debts because they have to deal with an insurer.

But disputed credit accounts are a bigger concern since their use has ballooned in the past few years. One FHA lender compared borrowers with disputed credit accounts to those during the housing bubble who applied for "stated income" loans in which the lender did not verify the borrower's income.

"If you have a lot of revolving debt that you're disputing, there's a liability there," says this lender, who requested anonymity. "By excluding it, they have this extra debt that hasn't been recognized in the underwriting process."

Christopher J. Willis, a debt collections litigator at Ballard Spahr, says he was taken aback by the government agency's decision to adopt a policy making it harder for borrowers to obtain loans.

"This will reduce FHA loan volume and create more compliance problems for originators," Willis says. "It seems to have the impact of inducing consumers to choose between getting FHA approval for a loan and paying off the debt they owe. We likely won't see a surge in the payment of old debts, because the more likely scenario is they just won't get a mortgage."

The only remedy for consumers, Willis says, is to challenge an inaccurate credit report under the Fair Debt Collections Practices Act, which prohibits debt collectors from reporting inaccurate information about a debt. Doing so can take months.

Disputed credit accounts or those in collections typically trigger manual underwriting, meaning "a set of human eyes looks at the loan and has a plan to correct it," says HUD spokesman Sullivan.

"It's not about denying access to credit to these borrowers," he says. "It's about trying to figure out through manual underwriting what's going on, as opposed to going through automated underwriting and passing them through the pipeline, when they could be at higher risk of default."

In February, the Obama administration projected in its budget proposal that FHA's mutual mortgage insurance fund's capital reserve account will be depleted in the next year. The account holds a balance of $4.7 billion and has a capital reserve ratio of under 0.3%; Congress requires that the capital reserve ratio be at least 2%.

Glen Corso, managing director of the Community Mortgage Banking Project, a trade group of small and midsized mortgage lenders, says it's hard to predict how many borrowers will be affected by the new guidelines. Some members of his trade group have estimated that 30% to 60% of FHA business may be ineligible, he says.

"We have never seen any rationale from HUD for this rule change, nor have we seen any performance data to show that it is necessary or appropriate," says Corso.

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