You’ve gone through the work to get a pre-approval letter in hand for your FHA loan, only to have it rejected during the underwriting process. It can be frustrating and confusing to figure out what happened and why, especially after you’ve gone through the steps of learning how to apply for a 203(k) loan.
A pre-approved FHA loan then denied may make you feel like your plans to buy or renovate a home are in jeopardy, but it’s not the end of the road. You can get answers from the lender, clarify or fix the roadblocks, and reapply—or consider alternative funding.
Top Reasons FHA Loans Are Denied
A denial may not be a surprise if your credit score is on the lower end or you haven’t met all the basic requirements of an FHA loan. Besides trying to get an FHA loan with bad credit, however, a denial can also occur simply based on communication flaws with the loan officer or missing documentation.
Here are three reasons why an FHA loan denied before closing is possible:
#1 Low Credit Score
While 580 is the minimum for an FHA loan with a 3.5% down payment (or 500 for a 10% down payment),1 those are the FHA’s bottom lines. Each lender has a minimum standard that’s almost always higher than the FHA’s.
And while you probably met the lender’s minimum (usually somewhere between 580 and 640) during pre-approval, this may not be enough for final approval or even a conditional approval.
Credit scores are part of a weighted calculation. If you’re on the lower end of what they’ll approve, they may want other factors, like total debt or income history, strong enough to counterbalance a low credit score.
#2 High DTI
Your debt-to-income ratio (DTI) represents how much you pay each month in total debt—like current or requested mortgage, loans, or credit card debt—compared to your monthly gross income.
The FHA maximum is 43% (vs. 36% for conventional mortgages), although as high as 50% can be acceptable with extenuating circumstances.1
But just like a credit score, your DTI is one of multiple factors at play in your mortgage loan application. On its own, a high DTI may be acceptable, but if it’s accompanied by a low credit score, poor credit card payment history, or other red flags, it can contribute to a loan denial.
#3 Sourced Funds
All funds involved in an FHA loan have to be sourced. This means tracing where they came from. (Meaning you can’t show up at closing with a mysterious pillowcase full of cash.) Final approval (or perhaps a conditional loan approval) will typically require documentation such as:
- Bank statements showing funds that have been in your account for at least six months2
- Transaction details and sources tracing more recent deposits
- Donor letters explaining any gift or grant source and whether repayment is required
What to Do if Your Pre-Approved FHA Loan Is Denied
There may be several reasons FHA loans are denied. But take a deep breath—you can take steps to turn a no from this lender into a maybe, or swap it for a yes from another lender.
Take these steps to resolve a denial of an FHA loan application:
1. Find out why
Ask your loan officer for a detailed explanation to help guide your next steps to full or conditional loan approval. If your credit score was a factor, they’re legally required to provide a letter that details at least two factors in your credit history or credit report that led to their decision.
2. Provide missing information
If there are any extenuating circumstances for factors that led to the denial (such as illness, a death in the family, or wrongful termination) provide letters of explanation and request a second look.
3. Improve your credit report
Review your credit history, fix any errors, negotiate with debtors, and square away as many outstanding payments as you can before resubmitting your application.
4. Work with another lender
Shop around for a lender that has different requirements and terms that you can meet, like closing cost amounts or late payment forgiveness.
5. Increase your down payment
Save for longer and apply for gifts, grants, and no-interest loans from state, local, and nonprofit down payment assistance programs. Then, when you’ve saved up more money in the bank, you can offer a higher down payment to bolster your application.
6. Explore other options
Homebuyers can explore low-to-no down payment options from Fannie Mae, Freddie Mac, USDA, and the VA. Homeowners seeking renovation funds can also consider home equity or personal loans, or a sale-leaseback program.
Consider a Residential Sale-Leaseback Program
Residential sale-leaseback programs are an alternative real estate option for those who want to free up cash and stay in their homes. With a residential sale-leaseback, you sell your home to an investor and receive 100% of your home equity in cash.
At closing, you can also sign a lease agreement that provides:
- The legal right to remain in your home as a renter as long as you choose
- A pre-agreed rental rate that is locked in for one to five years
- Documented limits on future rent increases
There are many sale-leaseback benefits. Unlike an FHA loan, you can use the cash generated as you wish, with no oversight. Plus, you can reduce monthly housing costs, as a residential sale-leaseback provider will often take over property tax, homeowner’s insurance, and covered repairs and maintenance.
Being pre-approved for an FHA loan doesn’t guarantee your mortgage loan will reach conditional approval or final approval, but there are steps you can take if it’s denied. Once you understand why your loan was denied, you can ask to clarify issues, improve your financial portrait, or work with another lender. Take a moment to consider the pros and cons of a 203(k) loan, and consider other options. You can seek other low-cost or even debt-free options like a residential sale-leaseback program to earn the funds you need to buy or remodel your home.