7 Reasons Why an FHA Loan Might Fall Through Prior to Closing

An FHA loan can “fall through” or get rejected during the mortgage underwriting stage for a number of reasons. As a borrower, it’s your job to prevent these scenarios from occurring.

Ten years ago, a reader asked us if they could get denied for an FHA loan after they’d been pre-approved by a mortgage lender. (The short answer is “yes.”) That article has since generated thousands of views, which means this is a major concern for borrowers.

So, here are five things to know right off the bat:

1. Mortgage pre-approval is a preliminary step that does not guarantee you will be approved for a loan.
2. Pre-approval takes place before underwriting, which is a deeper and more thorough screening process. 
3. An underwriter might identify problems that were missed during the initial application process.
4. An FHA loan might “fall through” due to a low credit score, insufficient funds, too much debt, and/or property-related issues.
5. You’re not fully approved for a loan until the underwriter marks you as “clear to close.”

What It Takes to Qualify for an FHA Loan

FHA home loans are insured by the government, with oversight from the Federal Housing Administration. This agency falls under the Department of Housing and Urban Development, or HUD. But the actual funding comes from a lender in the private sector.

As a borrower, you need to understand this relationship because it affects your ability to qualify for an FHA loan. In short, you need to meet both the lender’s requirements and the FHA’s minimum qualification criteria.

Generally speaking, FHA loans require the following:

• A down payment of at least 3.5% of the purchase price or home value
• A credit score of at least 580 for the 3.5% down payment option
• A debt-to-income ratio no higher than 43% (or 50% for some borrowers)
• Stable income that’s likely to continue for at least the next few years
• Enough funds in the bank to cover the down payment and closing costs
• A home appraisal to determine the property’s current market value
• A home in good condition that meets the FHA’s property requirements

Any deviation from these requirements could cause an FHA loan to be denied up front during pre-approval, or fall through later during underwriting. So let’s take a closer look at them…

7 Reasons Why the Loan Might Fall Through

By understanding the reasons for mortgage denial, home buyers can take proactive steps to avoid those disappointing scenarios. So let’s look at some common reasons why an FHA loan might fall through prior to closing.

1. Low credit score with history of missed payments

The official minimum credit score required for an FHA loan is 500, according to HUD. But you’ll need a score of 580 or higher to qualify for the minimum 3.5% down payment.

Your credit score indicates how you have borrowed and repaid money in the past. If a person has a history of missed payments or delinquencies, they’ll likely have a lower score. This represents a higher risk and might make it harder to qualify for an FHA loan.

On the other hand, borrowers with higher scores have an easier time getting approved, and usually qualify for lower interest rates as well.

When you first apply for an FHA loan, your mortgage lender will check your credit to see if you meet their requirements. But that might not be the only credit check. Some lenders will run another credit check shortly before closing, to see if anything has changed.

If new and derogatory information appears on your credit report prior to closing, it could lead to FHA loan denial—even if you’ve already been pre-approved.

The best way to maintain a good credit score is by paying all of your debts on time. This applies to credit cards, car loans, student loans, and other recurring debts.

2. Too much debt with the addition of a mortgage payment

Mortgage lenders use the debt-to-income ratio, or DTI, to determine how much debt you are currently carrying in relation to your monthly income.

For most borrowers, the maximum DTI ratio for an FHA loan is 43%. But borrowers with compensating factors (such as additional cash reserves) could be allowed to have a debt-to-income ratio as high as 50%.

If a mortgage underwriter reviews a loan file prior to closing and determines that the borrower has too much debt, it could cause the loan to fall through.

There are two ways to reduce your total debt-to-income ratio (if necessary). You could pay off some of your debts, or find ways to increase your income. Either one of these strategies could improve your chances of qualifying for an FHA loan.

3. Not enough money in the bank for the upfront expenses

When you apply for mortgage loan, your lender will review your bank statements and other financial records. They do this to ensure you have enough money in the bank to cover the minimum 3.5% investment mentioned above, along with your closing costs.

If you don’t have enough “cash to close,” as it’s called, your FHA loan application could be denied. Similarly, the loan could fall through later on during the underwriting stage, if the underwriter flags it for insufficient funds.

First-time home buyers are often caught off guard by the amount they have to pay at closing. These costs typically range from 3% to 6% of the home’s purchase price, which can add up to thousands of dollars. So you want to prepare for this in advance.

Your lender will give you a closing cost estimate when you first apply for a loan, followed by a finalized breakdown a few days prior to closing.

To avoid having your FHA loan fall through due to insufficient funds, start saving money as early as possible. The more money you can save, the easier it will be to qualify.

4. Unstable and unpredictable income

The official lender’s handbook states that the borrower’s “income must be reasonably likely to continue through at least the first three years of the Mortgage…”

It goes on to explain that mortgage lenders “may only consider income if it is legally derived and, when required, properly reported as income on the Borrower’s tax returns.”

Lenders typically require several documents to verify a borrower’s income. These include pay stubs, W-2 forms, and tax returns for the past few years. Self-employed borrowers may need to provide additional documents like profit-and-loss statements.

An FHA loan could fall through if the underwriter determines that the income source is unstable, unpredictable, or unlikely to continue through the first few years of homeownership.

5. A “fixer-upper” that needs serious work to be habitable

All FHA purchase loans require a home appraisal, in order to determine two things:

First, the appraiser will estimate the current market value of the property, to make sure it justifies the loan amount. The appraiser will also evaluate the overall condition of the home, to make sure it meets the “minimum property requirements” for an FHA loan.

These property requirements are not as strict as some people think, but they can exclude certain types of properties from FHA financing.

This program is intended for properties that are move-in ready, but not “fixer-uppers.” If the appraiser identifies significant issues with the property’s condition, such as safety hazards or major structural defects, the loan might be denied.

Note: Everything mentioned above applies to a standard FHA home purchase loan. If you want to buy a house that needs work, check out the FHA 203(k) rehabilitation loan program. It allows borrowers to purchase and rehabilitate a home, all with one mortgage product.

6. The house appraises low, and the seller won’t budge

Even if the property meets FHA’s minimum property standards, the appraiser might determine that the property’s value is lower than the agreed-upon purchase price.

If this happens, the borrower might need to come up with additional funds or renegotiate the purchase price. If the seller refuses to lower the price to match the appraisal, and the home buyer cannot cover the difference, the loan might end up falling through.

Many home buyers who use FHA loans include an appraisal contingency within their purchase agreements, for this very reason. It gives you a way to back out of the deal if the appraisal comes in low, without sacrificing your earnest money deposit.

7. The borrower wants to buy a vacation or investment home

FHA loans are intended for primary residences, not investment properties or vacation homes.

The Federal Housing Administration defines a principal or primary residence as: “a dwelling where the Borrower maintains or will maintain their permanent place of abode, and which the Borrower typically occupies or will occupy for the majority of the calendar year.”

Attempting to buy a vacation home or a rental property could lead to mortgage denial.

Note: These aren’t the only factors that could cause an FHA loan to fall through. For example, a bankruptcy within the past two years could also lead to mortgage denial. These are just some of the most common examples that borrowers might encounter.

How to Avoid the Dreaded Mortgage Denial

When preparing to buy a home, there are certain steps you can take to reduce the chance of mortgage rejection. It requires patience and persistence, and it won’t happen overnight. But it’s still worth the effort.

Here are some proactive steps that could help you qualify for an FHA loan:

• Build and maintain a good credit score by paying all of your bills on time.
• Start saving for the down payment and closing costs as soon as possible.
• Consider paying down some of your debts, if your DTI ratio is too high.
• Shop for a well-maintained home that will likely meet FHA property standards.
• Make a smart offer based on sales data, to avoid a low appraisal situation.
• Keep employment stable and avoid changing jobs during the loan process.
• Avoid taking on new debt or making major purchases during the process.

Disclaimer: Mortgage transactions can vary from one borrower to the next due to a wide range of factors. As a result, portions of this article might not apply to your situation. This guide was created for a general audience and does not constitute financial advice.