With all of the talk about foreclosures and stagnant home sales it is easy to overlook the fact that people are still out there trying to buy houses. For the vast majority of people, buying a house still means qualifying for a mortgage. With that in mind, what does it take to get a bank to sign off on a mortgage these days?
TUTORIAL: Mortgage Basics: Introduction
FHA Still in the Game
It would take a separate column to detail all of the differences between Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA). The FHA does not make loans, does not buy mortgages and operates basically as a government-subsidized mortgage insurance company. The FHA is still operating and homebuyers can still get FHA-insured loans. Mortgage qualification rules are still changing in the wake of the subprime crisis and there is still some confusion between proposed rules and implemented rules. Moreover, there is a difference between FHA minimums and the minimums of the banks that write FHA-insured mortgages. (Don't be overwhelmed when filling out these forms. For more, see Understanding FHA Home Loans.)
What Are the Rules?
To qualify under FHA rules, a borrower needs a minimum score of 580 if he or she wishes to make only the minimum 3.5% down payment. If the credit score is below 580, it is still possible to get an FHA loan, but the down payment requirement jumps to 10%. In practice, it seems increasingly difficult to find banks that will fund loans (even with FHA insurance) with scores below 620.
Along with the FICO score, other factors play into the credit assessment. Late payments within the 12 months prior to application are problematic, particularly if those late payments apply to mortgage or loan payments. Likewise, any liens, defaults or bankruptcies are going to play poorly with lenders. (For related reading, see The Importance Of Your Credit Rating.)
Lenders need to see two years of employment with stable income, and those who have transitioned from externally employed to self-employed within the last two years may have a much more difficult time qualifying. With more and more people facing layoffs, this is an increasingly significant issue.
Ratios And Other Requirements
There is a limit to how many other outstanding obligations a prospective borrower can have. The ratio of mortgage payment to gross monthly income needs to be 31% or lower and likewise the ratio of total monthly obligations to gross income needs to be below 43%. Beyond that, the FHA has become much more strict with respect to home inspections and sellers are finding it increasingly difficult to meet these demands.
FHA Not the Only Game
FHA loan standards often dominate discussions of mortgages, but they are only part of the story. FHA loans were intended to assist borrowers who would otherwise have difficulty qualifying for mortgages, and as such they were never intended to be "market standard" loans. Right now, normal bank lending standards are fairly conservative. Banks are not only trying to repair their balance sheets (and avoid more bad debt), but they are also enjoying favorable (meaning "cheap") funding costs that allow them to make a little bit of money without increasing lending. What's more, the mortgage loan buyers have become much more demanding and pushed those higher standards on to banks.
The average loans bought by Freddie Mac through June of this year featured an average down payment of 29% and an average FICO score of 751 - up significantly from 23% and 707 in 2007. While lenders with quality FICO scores are still getting loans (and favorable rates), less credit-worthy borrowers are finding it harder and harder and are being forced to put up more in down payments or take mortgage insurance. (For more on Freddie Mac, read Fannie Mae, Freddie Mac And The Credit Crisis Of 2008.)
Likewise, there are fewer unconventional options for borrowers. Negative amortization loans and other housing bubble baubles are a non-starter for many banks now. At this point, many banks even refuse to underwrite loans where the loan-to-value ratio is above 80%. Along similar lines, banks have gotten more aggressive with housing inspection requirements and appraisals - a swing back to a much more conservative outlook than the market has seen in over 10 years.
The Bottom Line
There are still occasional weekly reports of small bank failures and a few large banks like Bank of America (NYSE:BAC) and Citigroup (NYSE:C) look a bit shaky. Overall, though, the U.S. banking sector is back on its feet (even if the legs are a bit wobbly) and has funds on hand to loan. Unfortunately, those lendable funds have to compete with other money-making options like buying and holding Treasury bonds and many banks have been slow to hand out loans to all but the healthiest borrowers. This really is an environment where banks do not want to lend to you unless you don't really need the money. At this point, then, anyone shopping for a mortgage had best be prepared for a gauntlet. Borrowers with very clean credit (FICO score of 750 or higher), stable employment and the capacity to make a 25% down payment have very little to fear. Below those levels, though, would-be borrowers had best be prepared to shop around a bit and accept that they may have to agree to mortgage insurance to get a loan done. (It's possible to use a second mortgage to avoid this fee, but is it in your best interest? For more, see How To Outsmart Private Mortgage Insurance.)