What Are FHA Compensating Factors And How Do They Work?

6 Min Read
Updated Dec. 28, 2023
Happy family looking at new home almost done with construction.
Written By Kevin Graham

FHA loans allow the possibility of homeownership or refinancing for a better financial situation even for clients who may not qualify for other mortgage options. The most visible way this shows up is in more flexible credit requirements. FHA compensating factors are a lesser known form of assistance, but they may be helpful for many.

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How Compensating Factors Work

Compensating factors are elements of your financial profile or housing goals that make lenders or mortgage investors more forgiving of other areas where your qualifications may not be as stellar. Because you’ve demonstrated your preparedness in certain areas, there may be more flexibility in others. In some cases, this could make the difference between qualifying for a loan and not.

What we’ll go over are the policies of the Federal Housing Administration (FHA). Keep in mind that lenders may have their own policies based on their risk tolerance. Rocket Mortgage® doesn’t necessarily consider everything we’re going to talk about when you apply. Make sure to speak with one of our Home Loan Experts about the specifics of your situation..

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What Are Compensating Factors For FHA Loans?

When lenders look at compensating factors, there are several they can consider in approving FHA loans. If you have these working in your favor, you may be able to qualify even if you have a slightly higher debt-to-income ratio (DTI). Here’s the list:

  • Cash reserves
  • Significant additional income
  • Residual income
  • No discretionary debt
  • Minimal increase in housing payment
  • Energy-efficient homes

Cash Reserves

When we refer to reserves in mortgages, we mean the number of months of mortgage payments that could be covered if you had a loss of income or other event that put a strain on your finances.

In order to qualify for this compensating factor, you’ll need to have 3 months’ worth of mortgage payments available if you’re buying a one- or two-unit property. If your property is three or four units, you’ll need reserves covering payments for 6 months.

Note that your reserves have to be verified and documented. Assets used for this can’t include closing costs or any cash out or cash back received at closing. Borrowed funds also don’t count.

Significant Additional Income

When lenders do the initial calculations on what you can afford in terms of a mortgage payment, they’re looking at your effective income. The FHA partly defines your effective income on the basis that it has a likelihood of continuing for at least 3 years after your loan closes.

However, things like overtime and bonuses aren’t always included in effective income because these can be highly variable. But if you can show that you’ve received income from select categories for at least a year, and it’s likely to continue, that’s viewed positively. The categories are as follows:

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

Residual Income

Residual income is the amount of money you have left over after all of your debts are paid off each month. If you have a certain amount of money left over, you’re viewed as a potentially safer borrower in the eyes of the FHA.

The amount of residual income you should have for this to apply to you is based on where you live and your loan amount. The FHA follows the VA’s guidelines for residual income.

No Discretionary Debt

When the FHA refers to discretionary debt, it’s referring to financial obligations outside your house payment. You can have credit cards, but they have to be paid off every month. Additionally, you have to show that the cards have been open for at least 6 months and that you’ve paid them off each month.

In general, when you’re qualifying with other debts, you want to have a DTI of 45% or less in order to be eligible for the most possible loan options. The FHA doesn’t always have hard and fast guidelines regarding what your DTI should be.

It depends on your situation, accounting for your credit score and several of the things mentioned here. However, it’s important to note that the automated FHA underwriting system won’t approve DTI above 57%.

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Minimal Increase In Housing Payment

When we speak of house payments, it can refer to either your current mortgage payment or your existing monthly rent. There may be leniency even if you don’t otherwise qualify mathematically if you can prove both of the following:

  • The new mortgage payment you would have doesn’t exceed your current housing payment by $100 or .5%, whichever is lesser
  • You’ve had no more than one late payment in the last 12 months. If you’re taking cash out, you can’t have any late payments to qualify for this compensating factor.

Energy-Efficient Homes

If you’re building a new home that meets energy-efficiency standards set by the Department of Housing and Urban Development (HUD) or the International Energy Conservation Code. The qualification here gets a bit complicated and you can also bring existing homes up to date, so speak with your lender about your situation.

Other Qualifying Factors For FHA Loans

Compensating factors are certainly things that lenders can take into account when looking at an FHA loan approval, but there are also several things that lenders look at every time they consider a borrower for qualification.

  • Down payment: To qualify for an FHA loan, you’ll need at least a 3.5% down payment. However, there are advantages to a down payment of 10% or more. In addition to helping you get a better rate, with a down payment at this level, monthly mortgage insurance premiums stop after 11 years.

  • Credit history: Most lenders will require that you have a 580 median FICO® credit score. You can get an FHA loan with a score of 500 or better, but it requires a 10% down payment and very few lenders do these. You’ll also pay a higher rate. It’s important to note that if you have any derogatory marks on your credit like things in collections, past bankruptcies or foreclosures, you won’t qualify for any of the compensating factors mentioned above.

  • Occupancy: You have to live in the property as your primary residence. You can’t use an FHA loan for a vacation home or investment property.

The Bottom Line

Every time you apply for a loan, your lender looks at factors like your income, assets and credit. However, if your application is weak in one of these areas, there are FHA compensating factors that lenders consider so that your strong points counterbalance your weaker areas.

Examples of compensating factors include having significant cash reserves, plenty of documentable additional income and a lack of discretionary debt. It’s important to note that lenders have their own policies and may or may not consider some of these factors.

If you have questions regarding your individual circumstances, you can  today and see what you qualify for.

Find out if an FHA loan is right for you.

See rates, requirements and benefits.