New FHA Collections guidance that set new guidelines for dealing with collections, judgments & disputed credit accounts
First a Few definitions are in order
- Automated Underwriting System (AUS) – This is where the loan is approved by any of
several automated loan risk systems from Fannie Mae, Freddie Mac or in the case of FHA the system is called the FHA Total Scorecard
- Manual Underwriting – In the Case of FHA either the FHA Total Scorecard System cannot approve a loan or in some cases as noted below a loan must be downgraded to a manual underwrite. In the case of a manual underwrite the allowable debt to income ratios and other factors have lower thresholds so the borrower is not put in a position that would create a higher risk of foreclosure.
Ok now we’ve got that out of the way here are the FHA changes to Derogatory credit
when you are qualifying for a home FHA Home Loan Today:
If your loan is being manually underwritten, then an explanation for all owing
collections & judgments is needed. Currently nearly all underwriters are requiring an explanation anyway, however this clarifies that an explanation is mandatory and is no longer up to underwriter’s discretion.
From FHAs standpoint the letter will be used to determine if the collections or judgments were from the borrower’s disregard for financial obligations, the borrower’s inability to manage debt or extenuating circumstances. If the loan receives an Approve/Accept response from the AUS then this policy does not apply, but even in the situation of an Approve/Accept most underwriter’s still require letters of explanation for derogatory credit (that is still being left to underwriter’s discretion though).
Regardless if the loan is being manually underwritten or has an AUS Approval, owing FHA collections will have a greater impact on someone’s ability to qualify – FHA is now requiring a “capacity analysis” of collection accounts with an aggregate balance equal to or greater than $2,000 (this includes non-borrowing spouse’s in community property states such as Texas). The following guidelines do not apply if the outstanding balance on all collection accounts is less than $2,000 (again, this includes non-borrowing spouse’s in community property states). Also keep in mind that all medical collections and charge off accounts are excluded from this guidance.
“Capacity analysis” includes any or all of the following actions depending on the borrower:
- At the time of or prior to closing, payment in full of the collection account (verification of acceptable source of funds required).
- The borrower makes payment arrangements with the creditor. If the borrower has entered into a payment arrangement with the creditor, a credit report or letter from the creditor verifying the monthly payment is required. The monthly payment must be included in the borrower’s debt-to-income ratio.
- If evidence of a payment arrangement is not available, the lender must calculate the monthly payment using 5% of the outstanding balance of each collection, and include the monthly payment in the borrower’s debt-to-income ratio.
Summary: What this means is when the total of collections accounts exceeds $1,000 then the owing collection accounts will either need to be paid in full, payment arrangements need to be made, or if a payment arrangement isn’t made and the account is not paid in full, then 5% of the balance of the collection will be included as a payment when calculating the debt to income ratio.
Judgments are now be required to be paid in full or be on a payment plan with at least 3 months of payments being made.
The borrower must provide a copy of the agreement and evidence that payments were made on time in accordance with the agreement, and a minimum of three months of scheduled payments have been made prior to underwriting approval. Borrowers are not allowed to prepay scheduled payments in order to meet the required minimum of three months of payments.
FHA also requires owing judgments from a non-purchasing spouse in a community property state to follow the same guideline. Note this applies to FHA loans only. With Conventional loans in most cases Judgments must be paid and released.
If the Judgement is a Government Tax lien the Underwriter may require Payment in full and the Judgement released before allowing your FHA loan to Proceed.
Disputed accounts are being handled differently than they have been in the past.
If the cumulative outstanding balance of disputed “derogatory credit accounts” of all borrowers is equal to or greater than $1,000, the mortgage application must be downgraded to a “Refer” and an underwriter is required to manually underwrite the loan.
If the cumulative outstanding balance of disputed derogatory credit accounts of all borrowers is less than $1,000, a downgrade is not required. Certain accounts are excluded, such as disputed medical accounts & disputed derogatory credit accounts resulting from identity theft, credit card theft, or unauthorized use (however in the latter a letter is needed from from the creditor, or other appropriate documentation to support the dispute, such as a police report disputing the fraudulent charges).
“Derogatory credit accounts” are defined as
- disputed charge-off accounts
- disputed collection accounts
- disputed accounts with late payments in the last 24 months.
Disputed derogatory credit accounts of a non-purchasing spouse in a community property state such as Texas are not included in the cumulative balance for determining if the mortgage application is downgraded to a “Refer”.
“Non-derogatory disputed accounts” are excluded from the $1,000 cumulative total. “Non-derogatory disputed accounts” include:
- disputed accounts with zero balance
- disputed accounts with late payments aged 24 months or greater
- disputed accounts that are current and paid as agreed.
In closing when dealing with FHA Collections it can be a bit tricky but with enough preparation your FHA Loan process should go smoothly. For questions about your specific situation feel free to call me direct.
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