DO YOU QUALIFY FOR AN FHA HOME LOAN? 

LEARN THE FACTS.

FHA loan programs were created to help people in the United States obtain homeownership, an integral component to the American Dream. This remains the goal of FHA today. Therefore, to help as many as prudently possible, FHA maintains a commonsense approach to underwriting, the process of reviewing a loan application to verify all information given and evaluate the borrower’s credit history to determine whether the borrower qualifies for the loan for which they have applied and to quantify the risk the lender will assume. What this means is that, as opposed to many conventional loan programs that use automated underwriting and approval systems, FHA loans are reviewed in detail to look at all aspects of the borrower’s qualifying criteria as well as the “big picture” to see if loan scenario makes sense and can be deemed an acceptable risk to the lender and FHA. Therefore, FHA approves loans that can be considered “outside the box”.

As a rule, FHA underwriters follow the “Four C’s” evaluation process. The Four C’s stand for Credit history, Capacity to repay, Cash for down payment and closing costs, and the Collateral there is a special “fifth C”, Compensating factors.

Credit History:

The FHA loan approval process is based on the philosophy that past credit history demonstrates most effectively a borrower’s attitude towards paying their bills and credit obligations. With that said, FHA does allow for more tolerance regarding past derogatory credit history, but previous poor credit performance must be accompanied by reasonable, thorough letters of explanation from the borrower. Also, FHA underwriters will review the credit history to determine whether past instances of derogatory credit show a pattern of poor credit behavior or are the result of reasonable isolated occurrences. Finally, an FHA underwriter will pay attention to the hierarchy of credit. What that means is that the most emphasis is placed on the review of previous housing expenses, followed by payments on installment debts (ex. auto loans and student loans), and then revolving debts (credit cards).

Here are some general guidelines regarding different types of derogatory credit. Keep in mind that there are exceptions to these guidelines. If you have questions or comments, please contact us.

Late Payments: Typically FHA requires that there are no mortgage late payments in the most recent 12 months and that there are no late payments on installment or revolving debt in the past six months. Most recent late payments in the past 24 months will require a letter of explanation from the borrower.

Recently Obtained Debts: Recently obtained debt must be explained to confirm that is has not been incurred to help with the borrower’s cash investment (down payment and closing costs) requirements. Also, credit inquiries in the past 90 days must be explained.

Collections: FHA does not officially require that collection accounts are paid off in order to qualify for FHA loan approval. However, individual lenders may require that all collection accounts are paid or that different types of collections accounts are paid (ex. medical related collections can remain unpaid but all others must be paid). Collection accounts must be explained by the borrower in writing.

Judgments: FHA does require that judgments are paid off before the borrower can qualify for FHA loan approval. The only exception to that rule is if the borrower has agreed with the creditor to make regular and timely payments on the judgment and documentation is provided that the payments have been made in accordance with the agreement. Typically a minimum of six payments is required in order to obtain the exception.

Chapter 7 Bankruptcy: FHA requires that the minimum waiting time is typically no less than two years from the discharge date. In addition, the borrower must have reestablished good credit or chosen to not incur new credit obligations.

If the borrower can show that the bankruptcy was caused by extenuating circumstances beyond the borrower’s control and that he or she has since demonstrated a documented ability to manage his or her financial affairs, the waiting period can be reduced to one year.

Chapter 13 Bankruptcy: FHA states that a Chapter 13 does not disqualify a borrower from obtaining FHA financing as long as the borrower can show that at least one year of the pay-out period has elapsed under the plan and that all of the required payments (and mortgage payments when applicable) have been made on time. Also, the borrower must receive permission from the court to enter into the mortgage transaction.

Foreclosure: FHA states that the minimum waiting period is three years for a borrower whose house has been foreclosed or who has given a deed-in-lieu of foreclosure. If the foreclosure was the result of a documented extenuating circumstances that were beyond the control of the borrower and the borrower has reestablished good credit since the foreclosure the three year waiting period may be waived. Extenuating circumstances include serious illness or death of a wage earner.

Pre foreclosure Sale (Short Sale): FHA does not currently have a policy regarding the time required to reestablish credit and obtain a new FHA loan after a short sale. However, the borrower must be able to qualify using standard FHA guidelines including the fact that they typically cannot have any late payments on their mortgage for the previous 12 months.

Consumer Credit Counseling Payment Plans: An FHA loan can be obtained by someone who has participated in a consumer credit counseling payment program as long as at least one year of the pay-out period has elapsed under the plan and all of the required payments have been made on time. In addition, the borrower must receive written permission from the counseling agency to enter into the mortgage transaction.

Delinquent Federal Debts: FHA states that if a borrower is presently delinquent on any Federal debt or has a lien, including taxes, placed against his or her property for a debt owed to the U.S., the borrower is not eligible for an FHA mortgage until the delinquent account is brought current, paid, otherwise satisfied, or a satisfactory repayment plan is made between the borrower and the Federal agency owed and is verified in writing. In this last situation, a history of six consecutive on-time payments must be verified. Existing tax liens on a borrower’s property can remain unpaid but they must take a subordinate lien position to the FHA loan. In addition, the payments to be made must be included in the borrower’s debt to income ratios.

Please note that exceptions can be made when extenuating circumstances can be documented i.e any medical related issues, bereavement, or any real form of tragedy or circumstances beyond your control.

Capacity to Repay:

When an FHA underwriter cites Capacity to repay, he or she is referring to a borrower’s anticipated amount of income and the likelihood that it will continue. As such, FHA loan guidelines call for the evaluation of the source of a borrower’s income to ensure that it can be verified, that it is stable and that it has a high likelihood to continue.

Income Stability: FHA does not put restrictions on the type of employment that a borrower has or on minimum length of time that they have held a position of employment. However, FHA loans do require that a borrower has at least two years of employment history. FHA allows that a borrower’s previous school or military experience satisfies the two year employment history requirement.

Regarding employment history, there are certain circumstances worth mentioning that may or may not preclude a borrower from qualifying for an FHA mortgage. As such, when these circumstances are present, written explanatory documentation is required.

Employment Gaps: Employment gaps that are longer than a month must be explained in writing

Frequent Job Changes: It is acceptable that a borrower frequently changes jobs in the same line of work as long as he or she continues to advance in income or benefits. In these circumstances, income stability takes priority to job stability.

Recent Return to Work Force: If a borrower has recently returned to the work force after an extended absence, there income can be considered effective and stable if the borrower has been employed for six months or more and he or she can document a two-year history prior to the absence from the work force.

Salaries, Wages and Other Forms of Effective Income:

Salary and Hourly Wages: When analyzing the stability of the current income for a salaried or wage earning employee, FHA underwriters examine the prior two years to assess the stability of the current income. If earnings are similar or increasing at a normal rate, they will most likely use the current base income. If income varies drastically they may choose to average the income. In order to make the assessment, the FHA underwriter will – in most cases – require that the borrower provide his or her last two paystubs that show year-to-date earnings and his or her IRS form W-2s for the past two years. The underwriter will typically use the base employment of the borrower when calculating effective income.

Overtime and Bonus Income: Overtime and bonus income may be used to qualify if the borrower has received it for the past two years and it is likely to continue. FHA underwriters will use a two-year average of the overtime and/or bonus income for qualifying purposes. Further, a written verification of employment must be obtained from the borrower’s employer that states that the overtime and/or bonus is likely to continue. If this type of income has been received for less than two years, the FHA underwriter can use his or her judgment to use the income. However, the reasoning for doing so must be justified and documented in writing. In the event that bonus income varies significantly from year to year, a period of more than two years will be used in order to calculate the average income.

Part-time / Second Job Income: Part-time / second job income, including seasonal employment, may be used for qualifying purposes if it has been worked uninterrupted for the past two years and there is a strong likelihood that it will continue. Seasonal employment is considered uninterrupted if the borrower has worked the same type of job for the past two years and expects to be rehired during the next season. Some examples of this include umpiring baseball games in the summer, working as a tax preparer in the spring, or working as a department store clerk during the holiday shopping season. If this type of income has been received for less than two years, the FHA underwriter can use his or her judgment to use the income. However, the reasoning for doing so must be justified and documented in writing. This guideline refers to part-time income as a job taken to supplement the borrower’s income from regular employment as opposed to a primary job of less than 40 hours a week.

Commission Income: Commission income must be averaged over the previous two years. The borrower must provide copies of signed tax returns for the last two years, along with his or her most recent two paystubs with year-to-date earnings. If the borrower has unreimbursed business expenses, they must be subtracted from his or her gross income. If the borrower has commission income that has decreased from one year to the next, significant compensating factors are required for loan approval.

Retirement and Social Security Income: Retirement and social security income require verification from the source (former employer, Social Security Administration) or federal tax returns. The FHA underwriter must be able to determine that the income will continue through the first full three years of the life of the loan.

Alimony, Child Support or Separate Maintenance Income: Income from these sources can be used for FHA qualifying purposes if the payments are likely to be consistently received for the first full three years of the life of the loan. The borrower must provide a copy of the final divorce decree, legal separation agreement, or voluntary payment agreement as well as evidence that the payments have been received during the past twelve months. This can be supported with documentation such as cancelled checks, deposit slips, tax returns and court records.

Interest and Dividends: Income from interest and dividends may be used as long as it can be supported with proper documentation to having been received for at least the past two year. The income must be averaged over the past two years. Acceptable documentation includes tax returns or account statements. If the borrower is withdrawing funds from the income source for purposes of cash investment in the home, the amount must be subtracted before projected interest or dividend income is calculated.

Military Income: In addition to base pay, military personnel may be entitled to additional forms of pay. Income from variable housing allowances, clothing allowances, flight or hazard pay, rations, and proficiency pay is acceptable provided that the likelihood that it will continue is verified in writing.

Government Assistance Programs: Income received from government assistance programs is acceptable if supporting documentation is provided that shows that the income is expected to continue through at least the first three years of the life of the loan. These programs include unemployment income and section 8 homeownership vouchers.

Rental Income: Rental income from properties owned by the borrower is acceptable as long as the FHA underwriter can determine through provided documentation that the rental income is stable. Rent received from investment properties, or other units of an owner-occupied multifamily property, may be considered stable income. Rent from boarders in a single-family property that is also the borrower’s primary residence is not acceptable unless the boarder(s) are related by blood, marriage or law and the rental income is also shown on the borrower’s tax returns. Rent from a property that is the borrower’s second home is ineligible.

For documentation of rental income, FHA underwriters will require a Schedule E of IRS Form 1040 and current leases. The qualifying rental income is the net cash flow and it can be established by either the borrower’s most recent Schedule E, if the Borrower owned the property in the previous tax year or copies of the current lease agreement if the property was not owned in the previous tax year. Generally, the lease should have at least a 12-month term.

Schedule E of IRS form 1040 return

Make the following adjustments to the net income shown on Schedule E to determine the Net Cash Flow:

Net Income
+ Depreciation
- Unallowed losses (if any)
+ Loss carryovers from previous years (if any)
______________________________________
Annual Operating Income

Annual Operating Income/12 months = Monthly Operating Income

Monthly Operating income
- PITI for the property
_______________________
Net Cash Flow

Lease Agreements

Make the following adjustments to the rent stated on the lease agreement to determine the net cash flow:

Deduct a 25% maintenance expense/vacancy factor.
Subtract the PITI for the property. If the net cash flow is positive, include it in the qualifying income.

If net cash flow is negative, include it with the monthly liabilities.

Auto Allowance and Expense Account Payments: FHA will accept only the portion of the automobile allowance income that exceeds related expenses for qualification purposes. The borrower must provide IRS form 2106 for the previous two years to establish the amount of income that may be added to gross income. In addition, the borrower’s employer must verify in writing that the payments will continue.

Trust Income: Income from trusts may be used if guaranteed, constant payments will continue through the first full three years of the life of the loan. Documentation required for FHA underwriting includes a copy of the Trust Agreement or other trustee’s statement that confirms the amount, frequency of distribution and duration of payments.

Self-Employed Borrowers: FHA underwriters consider a borrower with a 25% or greater ownership interest in a business or can otherwise exercise control over the business’ activities is considered self-employed. Income from self-employment may be considered stable if the borrower has been self-employed two or more years. The borrower is required to provide signed and dated individual tax returns, plus all applicable schedules and signed copies of federal business income tax returns with all applicable schedules for the last two years. The FHA underwriter must establish the borrower’s earnings trend over the previous two years.

Cash for Down Payment and Closing Costs:

Beginning January 1, 2009 The Housing and Economic Recovery Act of 2008 revised the National Housing Act to:

• Require that the FHA borrower “shall have paid, in cash or its equivalent...and amount equal to not less than 3.5% of the appraised value of the property...”
• Eliminate the variable FHA loan to value limits that were based on the combination of the property and the average closing cost of the State where the property is located (also know as the "down payment simplification"); and
• Limit the total FHA insured first mortgage to 100 percent of the appraised value, and require the inclusion of the upfront mortgage insurance premium (UFMIP) to be within that limit.

Understanding where you can get money for your down payment will help you when you are ready to apply for your FHA loan.

Acceptable sources of these funds include:

Earnest Money Deposit: If the amount of the earnest money deposit exceeds 2% of the sales price or appears excessive based on the borrower's history of accumulating savings, the deposit amount and source of funds must be verified. Otherwise, satisfactory documentation includes a copy of the borrower's canceled check or verification from the bank.

Savings and Checking Accounts: The lender must verify these accounts. The borrower will need to provide the last three most recent bank statements. If a large increase in deposits is present or the account was recently opened, an explanation and verification of the source of the deposit must be established. Non-sufficient funds, bounced checks, or account overdrafts will need to be reasonably explained.

Closing Cost: Effective January 1, 2009, closing cost may not be used to help meet the minimum 3.5% down payment requirements. Closing cost are not considered in the mortgage amount/down payment calculation for purchase money mortgages.

Gift Funds: An outright gift is acceptable if it is from:

1. A relative of the borrower,
2. The borrower's employer or labor union,
3. A charitable organization, or
4. A governmental agency or public entity that has a program established to provide homeownership assistance to low and moderate income families.

No repayment of the gift may be expected or implied. Furthermore, a gift letter signed by both the donor and the borrower stating the amount of the gift and that repayment is not required, provides the donor's name, address, phone number, and relationship to the borrower will be required. In addition, verification of the transfer of funds from the donor's account to the borrower's account, via copies of the donor's canceled check, for example, and the borrower's deposit slip or bank statement will be necessary.

Sales Proceeds: Sale of an asset is considered an acceptable source of income if the borrower provides:

1. Copy of the bill of sale or HUD-1 Settlement Statement (for the sale of a home),
2. Copy of the check or verification of funds transfer from the buyer of the asset to the borrower, and
3. Copy of the borrower's deposit slip or bank statement showing the deposit of the funds into the borrower's bank account.

Cash Saved at Home (i.e. Mattress Money): Cash must first be deposited in a financial institution or held by the escrow/closing agent. The borrower must provide an explanation of how the funds were accumulated and the length of time taken to do so. The lender must determine the credibility of the savings based on the borrower's income, spending habits, and history of using financial institutions, as well as considering how long it took to accumulate the funds.

Rent Credit: If the portion of a borrower's current rental payment is to be used to purchase the property the borrower currently occupies, the borrower will need to provide a copy of the rental/lease agreement showing an option to purchase with the clause stating how much of the rental payment is to be used as a rent credit. It is the lender's responsibility to show that the rent payment is above FHA's estimate of fair market rent. If the rent paid by the borrower is less than fair market or if the seller has agreed to permit the borrower to occupy the property rent-free, this amount must be deducted from the sales price as a sales concession before determining the borrower's maximum insurable FHA loan amount.

Seller/Lender/Realtor Credits: In a purchase transaction you will not only have your required down payment, but you will also have closing costs that need to get paid. To limit the total amount of funds that the borrower needs to bring to the table, the seller/lender or Realtor can agree to pay all or a portion of the borrowers closing cost. The combination of the seller/lender/Realtor credits may not exceed 6% of the purchase price for the borrower points, discounts, closing cost and/or prepaid items. The six percent is in total and not per entity. Neither of these parties may contribute any money towards the buyer’s required 3% down payment.

Collateral:

Collateral is referred to the value of your home. A licensed FHA appraiser must appraiser the property and the appraisal must be no older than 90 days from the date of closing. The value that the appraiser asses’ to your property will determine the loan amount and the loan to value of your new loan. A second appraisal is required on any loan amount over 417k, at 95%, and is in a declining market (all of the United States is presently in a declining market). On a 1 family home a drive by is required on any other property type a full appraisal is required as second appraisal.

Compensating Factors:

Compensating factors are best described as that little extra that can make a difference between a loan being approved or denied. They are not absolutes and may be interpreted differently by different underwrites and how much they may weight them in their overall decision making process.

How many compensating factors you need is also subject to an underwriter’s discretion. Obviously the more you have the better you chances are on getting approved if you loan is one that is a close call.

Here is an example of compensating factors:

• Taking a homebuyer education class
• Amount of down payment. Putting down 10% instead of 3%
• Debt Ratios significantly under the maximum
• Strong Credit or credit scores
• Time on the job. The longer the better.
• Time at current residence. The longer the better.
• Down payment has been saved by the borrower verses getting a gift
• The amount of money left in savings after the purchase, often called reserves.
• Change in current housing expense. A large increase in the borrowers housing expense would be unfavorable.
• No recent (last 12 months) derogatory accounts or prior derogatory accounts were caused by extenuating circumstances.

Some practical examples of using compensating factors might be:

• A borrower has a debt ratio of 31/42. However, the borrower’s current housing expense is $900 and the new housing expense will be $750. Obviously this borrower has shown they have the ability to manage a higher payment.
• A borrower has some 30 day late payments on consumer credit cards. However, borrower is putting down 15% of the purchase price of the home from their own savings.
• A borrower is currently paying $300 per month in rent. The new house payment will be $800. However, after the borrower puts down their 3% for their down payment, the will still have $2,500 in reserves.

Find a solution now. Get in touch with a Specialist to learn which type of financing can benefit you best. Don't wait any longer, our form takes less than 10 minutes to complete!

Take the first step by getting in touch with our resident FHA Specialist - "Terrence Tormey".  His experience will save you time and big $$$'s

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