FHA to reject borrowers in minor credit disputes

NEW YORK (CNNMoney) -- The Federal Housing Administration is about to make it even tougher to borrow money from Uncle Sam to buy a home.

Starting April 1, borrowers in ongoing disputes with creditors over debts of $1,000 or more may no longer qualify for FHA-insured loans. Even borrowers with perfect credit scores can be denied over a single $1,000 problem charge.

Before this, individual lenders decided whether debt disputes constituted grounds for denial. You could be fighting a charge, say a hospital bill, and your lender might still decide that your credit history merited an approval. Now, a lender will have to justify the approval to the FHA and back its decision with documentation.

The change is part of the agency's effort to reduce its risk as it grapples with a depleted reserve fund that has fallen below legally-mandated levels. The FHA insures mortgages which are originated by private lenders. To help bolster its capital reserves, FHA will also hike the insurance premiums it charges borrowers beginning in April.

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The requirements are for the homebuyer's own good, said Tiffany Thomas Smith, deputy press secretary for the U.S. Department of Housing and Urban Development, FHA's parent agency.

"It's a way of protecting consumers from getting into loans they ultimately can't afford," she said.

The new rule requires borrowers with loans in collection that add up to at least $1,000 to either pay off the debt, prove they're making payments on the disputed loans or explain why the disputed loan is somehow wrong -- and document their case -- before they can close on a FHA loan.

Disputed accounts going back more than two years, along with those related to fraud or identity theft, will not count against borrowers, according to the FHA, but lenders must get evidence, such as police reports, that document client claims of identity thefts or fraud charges.

Such prohibitions could slow the housing market recovery if fewer borrowers can secure FHA mortgages.

The loans are one of the few products available for homebuyers needing low down payment mortgages at competitive terms. Most FHA borrowers put down only about 3.5% of the purchase price.

Since the housing bust, FHA loans have at times exceeded 20% of all purchase loans and is still running at about 15%.

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Lenders that are underwriting the FHA loans will get final say on whether the loans go through. If the borrower's explanation of an outstanding debt and supporting documentation satisfy the bank, it can decide to issue the loan --but they run the risk of FHA rejecting it.

Lenders likely won't do that very often, however, according to Steve Habetz, a loan officer with Darien Rowayton Bank in Connecticut, unless the documentation strongly supports the borrower's view on the disputed charge.

"Any error made is going to be on the side of caution," he said. "Few lenders will approve the loan. They don't want to hold a 96.5% mortgage held on their own books if the FHA rejects it."