Reader question: “We want to use an FHA loan to buy a home because we’ve heard it’s easier to qualify, compared to a regular mortgage. At the same time, I wondering what might cause us to be turned down. Does the FHA deny loans for unqualified borrowers, or is it left up to the mortgage underwriter? How can you get denied for the FHA program? Like what are the most common reasons or rejection?”
Let me start by explaining the three “players” involved in a typical FHA loan scenario. Everything else will make more sense once you know the process works, and who is involved.
- Lender: An FHA loan is generated in the private sector by a bank, mortgage company, or credit union. They are like any other mortgage product in this regard.
- Federal Housing Administration (FHA): This agency is part of the federal government and falls under the Department of Housing and Urban Development (HUD). They insure loans that are made as part of the FHA mortgage-insurance program. This insurance protects the lender from financial losses in the event that the borrower defaults.
- Borrower: This is the person who applies for the loan, and uses the funds for the purchase of a home.
As a borrower, you would apply for an FHA loan through a lender. They would in turn provide the funds needed to purchase the house. That is where the money comes from. It’s important to understand that the government does not lend money to borrowers — they only insure the loan against default.
So you must meet two sets of criteria to be approved for a government-insured mortgage loan. You must meet HUD’s minimum guidelines, as well as the lender’s guidelines. This directly relates to how and when you can be denied for an FHA loan.
Generally speaking, there are two stages in the process where you might be turned down for financing. You can be denied up front when you first apply for a loan, or later on during the underwriting stage. The “red flag” of denial might be raised by the loan officer when you submit an application. Or it might be raised by the underwriter, who is responsible for ensuring the loan “checks out” in all regards.
Of course, I’m just being hypothetical here. You might sail through the process with no issues whatsoever. Let’s hope so.
The Automated Underwriting System
FHA loan applications are typically processed through an Automated Underwriting System (AUS). Think of a computer software program that evaluates borrowers based on certain criteria. The loan officer or underwriter will enter the borrower’s information into the AUS. This information comes from the loan application and includes the borrower’s income, debt level, credit score and other factors.
The AUS will then apply certain approval parameters to determine whether or not the borrower is qualified for an FHA loan. Usually, the AUS will produce one of two results — accept / approve, or refer. If it says “refer,” the mortgage lender’s underwriter must manually review the application file to determine eligibility.
This is where the process can go one of several ways:
- If the underwriter finds compensating factors to make up for whatever issue(s) was flagged by the AUS, the loan might still move forward.
- Chances are, the underwriter will ask the borrower for additional documents at this point, such as a written explanation of a certain withdrawal, documents relating to a previous foreclosure, etc.
- If he or she finds serious issues that make the borrower ineligible for financing (an excessive amount of debt, for example), the underwriter might deny the FHA loan. That would be the end of line, at least with this particular lender.
To recap: You could be denied by a loan officer on the front end of this process. In this case, your file would not even make it to the mortgage lender’s underwriter. You could also be turned down during the underwriting process itself. This is where the “rubber meets the road,” so to speak. It is the most intensive part of the review process. In some cases, borrowers can overcome “red flags” by providing additional documents, or by a writing letter of explanation (LOE) to satisfy the underwriter.
Let’s move on to discuss the most common reasons for FHA loan denial.
7 Reasons You Could Be Denied for an FHA Loan
So getting back to your main question: How can you get denied for an FHA loan? There are dozens of reasons actually. So let’s focus on the most common reasons for denial.
1. Credit score. According to the Department of Housing and Urban Development (HUD), you need a credit score of at least 500 to be eligible for an FHA loan. But, if you refer back to the three “players” above, you’ll recall that mortgage lenders can set their own guidelines. The minimum score cutoff varies from one lender to the next. But most want to see a credit score of 600 or higher. If you fall well below this range, you might be denied for an FHA loan. In fact, bad credit is one of the most common causes of denial — for any type of mortgage loan.
2. Down payment. You will need to make a down payment of at least 3.5% of the purchase price or the appraised value of the home, whichever amount is lower. That is the minimum down payment for the FHA program. If you cannot come up with this amount, you will likely be denied financing up front, by the loan officer. This will all come to light when the lender obtains bank statements to verify your assets. Also, if the funds you’re using for your down payment cannot be properly sourced, you might be denied for the loan. “Sourcing” is when the underwriter traces the money back to its source, like a particular deposit on a certain date.
3. Too much debt. This is another common reason for denial, especially in the wake of the recession when a lot of consumers racked up additional debt. Simply stated, if your debt-to-income (DTI) ratio is too high, you might be turned down by the lender. According to HUD, “the relationship of total obligations to income is considered acceptable if the total mortgage payment and all recurring monthly obligations do not exceed 43% of the gross effective income.” But the lender can make exceptions to this rule, and allow a higher DTI, if they find and document “significant compensating factors.” Still, most lenders draw the line between 45% and 50%. Any higher, and you will likely be denied for an FHA loan.
4. Insufficient funds to close. You need to have enough in the money in the bank to cover your down payment (item #2) as well as your closing costs. These funds can be provided in the form of a gift, or they can come from other legitimate sources such as your own income / savings. If they money is donated from a family member, you’ll need to obtain a gift letter. The bottom line is that if you don’t have the funds needed to close the loan, you will be denied financing.
5. Property appraisal. HUD has specific guidelines for homes being purchased with an FHA loan. The appraisal could cause your FHA loan to be denied in two ways. First of all, if the appraiser determines that the home is worth less than you’ve agreed to pay (in the purchase agreement), it will raise a red flag. The seller may have to lower the price in this scenario. Secondly, if the appraiser finds discrepancies that cannot be fixed, the loan might be denied. For example, if the bedroom does not have door or window access to the outside (a fire-safety requirement), it could be a deal-breaker. Many appraisal discrepancies can be fixed in order to keep the loan on track. Others are uncorrectable. Here’s an overview of FHA appraisal requirements.
6. Recent bankruptcy or foreclosure. Generally speaking, at least one year must have passed since the bankruptcy or foreclosure event. In some cases, the “waiting period” is even longer. A lot depends on the reasons behind the event. If you can prove that you were the victim of extenuating circumstances beyond your control, you might get approved for FHA financing in as little as one year. Otherwise, you might have to wait up to three years. This is another reason why borrowers get denied for FHA loans, especially with the hard financial times we’ve been through in recent years.
7. A combination of these factors. Any one of these factors is enough to cause an FHA loan denial. In other cases, it might be a combination of risk indicators and financial issues that leads to rejection.
These are some of the most common reasons why FHA borrowers get denied. But they are not the only reasons. There are other factors that can disrupt the lending process as well. This list addresses the kinds of issues that come up most often, based on our conversations with lenders over the years. A key takeaway from this lesson is that HUD allows for compensating factors and exceptions to many of their rules. So don’t be discouraged by anything you’ve read above. The only way to find out for sure if you qualify for an FHA loan is to apply for one through a HUD-approved mortgage lender.