Does FHA Require Collections to Be Paid Off?

The Federal Housing Administration (FHA) insures mortgages, making homeownership more accessible for borrowers who may not qualify for conventional loans due to credit history or lower down payments. A common concern for prospective homebuyers is how collection accounts on their credit report might impact FHA loan eligibility. This article clarifies the FHA’s specific stance on collection accounts and their implications for loan approval.

FHA Requirements for Collections

The FHA distinguishes between medical and non-medical collection accounts, applying different guidelines to each category. Generally, the FHA does not require borrowers to pay off all collections to qualify for a loan, though individual lenders may impose stricter requirements known as “lender overlays.” These lender-specific rules can sometimes mandate that collections be paid in full before loan approval.

Medical collection accounts are treated with more leniency by the FHA. These debts do not impact a borrower’s debt-to-income (DTI) ratio, and their payment is not required for loan approval. This approach acknowledges that healthcare costs can be unexpected and may not reflect a borrower’s overall financial responsibility. Regardless of the outstanding balance, medical collections are typically excluded from DTI calculations.

For non-medical collection accounts, the FHA guidelines are more specific. If the total balance of all non-medical collections is less than $2,000, these accounts generally will not affect loan approval. However, if the cumulative outstanding balance of non-medical collections reaches $2,000 or more, the FHA requires lenders to factor a hypothetical payment into the borrower’s DTI calculation. This hypothetical payment is typically calculated as 5% of the total outstanding non-medical collection balance. For instance, if a borrower has $10,000 in non-medical collections, $500 per month would be added to their debt calculations for DTI purposes.

Borrowers can avoid the 5% hypothetical payment rule for non-medical collections exceeding $2,000 if they establish a written payment plan with the creditor. In such cases, the agreed-upon monthly payment from the plan will be used in the DTI calculation instead of the 5% rule. While the FHA may not mandate payment, some lenders may still require payment in full, or a payment arrangement with a history of timely payments, due to their internal policies.

Impact of Collection Accounts on Loan Eligibility

Collection accounts, especially non-medical ones, can negatively affect a borrower’s credit score. A lower credit score, even if it meets the FHA’s minimum requirements, might lead to less favorable loan terms or increased scrutiny during the underwriting process. While recent credit scoring models are becoming less affected by collection accounts, many FHA lenders still use older models.

Unpaid collection accounts can also directly affect the debt-to-income (DTI) ratio, which is a crucial factor in loan approval. For non-medical collections totaling $2,000 or more, the FHA’s requirement to include 5% of the outstanding balance as a hypothetical monthly payment can increase a borrower’s total monthly debt obligations. This increase in the DTI can make it more challenging to meet the FHA’s maximum DTI thresholds, which are typically 46.9% for housing expenses and 56.9% for total debt for borrowers with credit scores of 580 or higher. Even if a borrower’s DTI falls within FHA limits, a high ratio might signal increased risk to lenders, potentially impacting approval.

The presence of collection accounts, particularly if they are disputed or significant in number or amount, might lead to a requirement for manual underwriting. Manual underwriting involves a more in-depth review of a borrower’s financial situation by a human underwriter, rather than relying solely on automated underwriting systems. This process entails stricter scrutiny of income, employment history, and credit behavior, often requiring additional documentation like letters of explanation for each outstanding collection account. While FHA guidelines allow for manual underwriting with collections, the lender must determine if the collections were a result of extenuating circumstances or a disregard for financial obligations.

Strategies for Addressing Collection Accounts

For borrowers with collection accounts seeking an FHA loan, several actionable steps can be taken to improve their eligibility. First, carefully review credit reports from all three major bureaus to identify any inaccuracies. Disputing incorrect collection accounts with the credit bureaus can potentially lead to their removal or correction, which may improve credit scores and remove the need for them to be considered in DTI calculations. It is important to note that certain credit disputes, especially on non-medical collections over a specific balance, may need to be resolved or retracted before final loan approval.

Second, negotiate with the collection agency. Borrowers may be able to settle the debt for less than the full amount, sometimes referred to as a “pay-for-delete” agreement, though agencies are not obligated to remove the account from credit reports even if paid. Obtaining written documentation of any settlement or payment agreement is important for mortgage application purposes. If paying off the entire balance is not feasible, establishing a formal payment plan for non-medical collections exceeding the FHA’s $2,000 threshold can be beneficial.

When a payment plan is established, the actual monthly payment will be used in the DTI calculation instead of the 5% hypothetical payment. Lenders will require proof of this payment arrangement. For FHA loans, documentation of consistent, timely payments on such plans is often required. Obtaining proof of payment, settlement letters, or confirmation that an account has been paid in full is essential, as this documentation will be needed by the lender during the underwriting process.