What are FHA compensating factors?

If you're close to qualifying for an FHA loan but fall short on one or two criteria, compensating factors may help you qualify. These are strengths in your mortgage application – like significant cash reserves or additional stable income – that can offset weaknesses to help you qualify. Learn how compensating factors work, and practical steps you can take to improve your odds of qualifying for an FHA loan.¹

Key takeaways:

• FHA compensating factors are strong points in your application that lenders accept as mitigating any weaknesses.
• Verified cash reserves or significant ongoing additional income not showing elsewhere are good examples of FHA compensating factors.
• FHA compensating factors alone don’t guarantee approval, as lenders may have their own standards.

What are the guidelines for FHA loan approval?

FHA loan requirements are less strict than conventional loan requirements because they are backed by the federal government.

To qualify for an FHA loan, your finances need to meet specific requirements, including:

• Credit score and down payment. Rocket Mortgage requires a credit score of at least 580 with a down payment of 3.5% for an FHA loan. ² Other lenders allow borrowers to qualify with a credit score between 500 and 579 with a 10% FHA down payment. 
• Debt-to-income ratio (DTI). FHA lenders consider a couple of DTI ratios to ensure you can afford your home. The housing expense ratio, or front-end DTI, compares your monthly mortgage payment, including taxes and insurance, with your monthly gross income. Your total DTI, or back-end DTI, compares your mortgage payment and all other monthly debts with your income. FHA DTI guidelines can be flexible. For example, a higher DTI may be allowed if you’re buying an energy-efficient home.
• Income and employment. Your income level affects your DTI. Beyond that, lenders also try to verify the likelihood that you'll continue receiving the income in the future.
• Property rules. Outside of an FHA Streamline refinance, you generally must occupy the home as your primary residence.³In addition to the home value supporting the loan you’re trying to get, the home must meet FHA minimum property standards for health and safety.

Automated vs. manual underwriting

FHA loans often use an automated approval system for mortgage underwriting. If the computer software reviews your data and determines that you present an acceptable risk to the FHA, it will approve your loan.

If the software denies your application, your lender may manually underwrite your application. This involves a human review of your finances, which can be more flexible than automated underwriting. While automated underwriting strictly applies the FHA DTI requirements, FHA manual underwriting ratios can be more forgiving.

How do FHA compensating factors work?

Think of an FHA compensating factor as a point in your favor that balances out weak points in your application.

Specific compensating factors can increase the allowable housing expense ratio on a manually underwritten loan to 40% and your overall DTI to 50%.

For all manually underwritten FHA loans from Rocket Mortgage, the minimum qualifying credit score is 640. Additionally, your mortgage payment can't exceed 31% of your gross monthly income, and your overall DTI can't exceed 43%.

It should be noted that each lender sets its own policies based on FHA guidance and their individual risk tolerance. Ask your lender about its requirements for FHA loans and what compensating factors it considers.

Which FHA compensating factors do lenders consider?

The FHA considers several compensating factors depending on the situation. The table below is taken from the FHA Single Family Housing Policy Handbook. When you read the qualifying ratios, the first number represents the housing expense ratio, and the second number is the total DTI.

Energy-efficient homes

Energy efficiency is a compensating factor because it's assumed you'll pay less for power. It also may increase the value of your home. The requirements for being considered energy-efficient are based on whether it’s new construction or an existing home.

Here’s an example of the requirements for new construction. To qualify for an energy-efficient home mortgage, the standard is based on the higher of the following:

• An energy code adopted by the Department of Housing and Urban Development (HUD)
• The applicable International Energy Conservation Code year used under state or local building codes
• Manufactured homes that are Energy Star labeled

Minimal increase in housing payment

A minimal increase over the previous mortgage payment may be considered a compensating factor. The qualifications for this are:

• The new mortgage payment doesn’t surpass the old one by more than $100 or 5%, whichever is less.
• No more than one 30-day late payment in the last year. If it’s a cash-out transaction, you can’t have any late payments in the last 12 months.

You must have a house payment of some sort for this to apply, whether it’s a mortgage or rent.

Significant verified cash reserves

Lenders may want you to show you have enough cash in reserve to cover your mortgage payment for a specific number of months if you were to lose income. This is referred to as having cash reserves.

According to the FHA, it can be considered a compensating factor if you have three housing expense payments in reserve when you’re buying up to two units. If you’re buying three or four units, you’ll need 6 months’ worth of mortgage payments.

Reserves are a big part of the reason that mortgage lenders check your assets. They want to know that you have savings available. Under FHA guidance, assets can be anything not used to pay closing costs, as long as they aren't gifts, borrowed funds, or cash received at mortgage closing.

Your cash reserves must be verified through statements from the asset accounts you’re using to qualify.

No discretionary debt

Your DTI is one of the things that determines exactly how much you can afford, along with your down payment and interest rate. To calculate it, add up your monthly installment and revolving debt payments and divide by your gross monthly income. Move the decimal over two places to express the result as a percentage.

The lower your DTI, the better. However, keeping a low DTI of 36% or less can signal that you're not overextending yourself.

A significant debt-related compensating factor, according to the FHA, is having no discretionary debt. In other words, the only thing that’s not paid off every month is your mortgage payment. Your house is considered good debt.

To qualify for this, you must have credit lines other than your mortgage open for at least 6 months, and your credit report must show that, for at least that time frame, you've paid off the full balance on those accounts.

Residual income

Residual income is defined as the amount of pretax income you have after accounting for personal debts and expenses. If you have a significant amount left over each month, that is a plus because you can better handle a decrease in income.

Under FHA income rules, the requirements to use residual income as a qualifying factor depend on your household size and your location.

Significant additional income

If you have income from any of the following categories that you’ve received in the past, it can improve your chances of qualifying:

• Overtime
• Bonuses
• Part-time work
• Seasonal income

To qualify, you must have received the income for at least a year, and it has to be likely to continue. Additionally, your DTI after income is counted can't exceed 37% for your housing expense ratio and 47% overall.

Larger down payment

Although not specifically listed as a compensating factor, a larger down payment makes you a lower risk to the lender. This is because your monthly payment is lower than someone who makes a smaller down payment.

You also have more equity in your home, which also reduces the lender's risk.

Though every FHA loan requires up-front and annual mortgage insurance premiums (MIP), the annual payments end after 11 years with a 10% down payment or more. Otherwise, you pay the annual MIP for the entire loan term.

Higher credit score

Also not specifically listed, a higher credit score can improve your chances of mortgage approval. Lenders and the FHA will often allow you to qualify with a higher DTI if you have a higher credit score, especially if you are approved through the FHA's automated underwriting system.

In addition to your down payment, your credit score influences your interest rate. In general, the higher your score, the more likely your lender will offer a lower interest rate.

How to maximize your chances of FHA loan qualification

We’ve talked a lot about compensating factors, but there are also actionable steps you can take to boost your chances of approval:

• Get your credit in order. This includes correcting any errors in your credit report, making on-time payments, and paying down your debts. You also should avoid taking on new debt before applying for a mortgage.
• Saving for a larger down payment will reduce your monthly payment and the lender's risk. While this can seem daunting, take advantage of the resources available to you. This could include down payment assistance and gift funds.
• Build up your emergency fund. Lenders like borrowers who have enough cash to cover their mortgage payments if they lose income. Having a rainy-day fund for this and other emergencies will better position you financially.
• Consider your full home affordability picture. You don’t want to be spending so much on your home that you have no room for anything else. Run the numbers and figure out a payment you’re comfortable with, not what you can be approved for.

FAQ

Before we wrap up, let’s answer a few more questions.

Do compensating factors guarantee FHA loan approval?

No. Having compensating factors doesn’t guarantee FHA mortgage approval. Lenders can set their own requirements in addition to FHA rules. If your mortgage is denied, lenders are required to tell you why. You can use this information to improve your chances of approval in the future.

What are some alternatives if I can’t get an FHA loan?

If you can't qualify for an FHA loan, consider a conventional or USDA loan. Both programs sometimes offer streamlined refinancing for borrowers with an existing conventional or USDA mortgage. Rocket Mortgage currently doesn’t offer USDA loans.

What is an FHA energy-efficient mortgage?

An energy-efficient mortgage, or EEM, allows borrowers to buy or refinance a home while making energy-efficient renovations. They are available for conventional, VA, and FHA loans.⁴ FHA EEMs are popular with many home buyers because the DTI requirements aren’t quite as stringent. Also, by making your home more efficient, you can save money on your monthly utility bills.

The bottom line: FHA compensating factors can help you get approved

If you’re on the edge of qualifying for an FHA loan, compensating factors can help you get approved. They might particularly benefit you if you have a lower credit score or need to qualify with slightly higher debt. Compensating factors can be anything from additional income to a minimal increase in your monthly mortgage payment.

If you're ready to apply for a mortgage, explore your borrowing options today with Rocket Mortgage.

This article is for informational purposes only and is not intended to provide, and should not be relied on for, medical, legal, financial, or tax advice. You should consult with a qualified professional for advice specific to your situation. Consumers should independently verify that any services, products, or programs referenced meet their needs and comply with applicable requirements.

¹Rocket Mortgage is not acting on behalf of FHA or HUD

²To qualify for this offer, you must meet all standard FHA eligibility requirements. In addition, your total mortgage payment, including taxes and insurance, cannot exceed 38% of your income, your debt-to-income (DTI) ratio cannot exceed 45%, and you must have 12 months of verifiable housing history immediately prior to your application, no late payments 30 days or greater in the last 12-months, and no derogatory marks on your credit report. Not available on jumbo loans. Asset statements may be needed, no more than 1 day of non-sufficient fund fees are allowed in the most recent 2 months prior to application. Additional restrictions/conditions may apply.

³The FHA Streamline program may have stricter requirements in some states. In order to qualify for the FHA Streamline program, an immediate .5% minimum reduction in interest and mortgage insurance premium is required. Some states may require an appraisal.

⁴ Rocket Mortgage is a VA-approved lender, not endorsed or sponsored by the Dept. of Veterans Affairs or any government agency.

Rocket Mortgage is a trademark or service mark of Rocket Mortgage LLC or its affiliates.