Reader question: “I’ve heard a lot about the qualified mortgage created by Dodd-Frank, and how it’s going to set the rules for mortgage lending next year. My question is, what is the minimum credit score needed to qualify under the QM guidelines?”

Let me start with a couple of definitions for the benefit of other readers.

The qualified mortgage is a set of rules outlined within the Dodd-Frank Wall Street Reform and Consumer Protection Act. The idea is to create a set of standardized criteria that will take some of the risk out of the lending industry. The qualified mortgage (QM) concept is intended to produce ‘safe’ home loans with a lower risk of default. In exchange for making such loans, lenders receive legal protection against consumer lawsuits. But the rules were only loosely defined by the Dodd-Frank Act — they are currently being finalized by the Consumer Financial Protection Bureau (CFPB).

A credit score is a three-digit number derived from information within a person’s credit report. They are an indicator of risk, as far as lenders are concerned. A low score indicates a borrower who has had trouble repaying debt obligations in the past. In contrast, a high number indicates a responsible borrower who pays his or her debts on time and in full. The FICO credit-scoring range (the one used by most mortgage lenders) goes from 300 to 850.

Now, getting back to your question. Is there a minimum credit-score requirement written into the forthcoming QM rules? In a word, no. At least none that have been spelled out within the proposed rules.

QM In a Nutshell

The Dodd-Frank Act offers nine features a home loan must have, in order to meet the definition of a qualified mortgage. Here they are in a nutshell:

  1. The loan’s principal cannot increase.
  2. The loan’s term cannot exceed 30 years.
  3. Balloon payments are prohibited in most cases.
  4. The borrower’s income and financial resources must be verified and documented.
  5. The loan must meet pre-established guidelines for debt-to-income (DTI) ratio.
  6. Fixed-rate loans must fully amortize.
  7. Adjustable / ARM loans must be “underwritten based on the maximum rate permitted during the first 5 years and on a fully amortizing payment schedule.”
  8. Lender points and fees cannot add up to more than 3% of the loan amount.
  9. Reverse mortgages must meet a separate set of QM standards set forth by the Federal Reserve.

In exchange for all of this, lenders are offered some degree of legal protection against lawsuits from borrowers. Items #4 and #5 above are key components of the qualified mortgage. In short, the lender must ensure that the borrower has the ability to repay the loan.

You’ll notice that credit scores are not mentioned here. In fact, the phrase ‘credit score’ only appears in a handful of pages within the Dodd-Frank Act, mostly in relation to disclosures. It is not mentioned anywhere in the qualified mortgage section of the act. So, if Dodd-Frank is truly the blueprint for the forthcoming QM rules, it seems unlikely that credit scores will be part of those requirements.

Granted, the rules haven’t been finalized yet. The CFPB has a January 2013 deadline for completing the definition of a qualified mortgage. But, as of right now, there is no mention of a minimum credit-score requirement.

That being said, borrowers should still care about their scores. Here’s why…

How Credit Scores Relate to Mortgage Approval

There are currently no QM requirements for credit scores. But that doesn’t mean they’re not important. On the contrary, this three-digit number can make or break your chances of getting a home loan. After all, it shows lenders how you have borrowed and repaid your previous debts.

Let’s say my credit history includes three credit cards, a car loan, and a student loan. My credit report will include all of these accounts, past and present. It will also show how well, or how poorly, I have made my payments on these obligations. Let’s further assume that I’ve missed a few car payments in the past, to the point of receiving a collection notice. This too will show up on my report.

The information within my credit report is then run through a computerized algorithm to produce a three-digit score. So the more negative information contained in the report, the lower the score. In this scenario, I would likely have a low credit score as a result of my previous delinquencies. Mortgage lenders will see this, and it will give them pause when considering me for a loan. If my past ‘transgressions’ have pushed my score below a certain point — say, 580 on the FICO scale — my application will probably be denied.

Most lenders have a ‘hard’ and ‘soft’ cutoff for credit scores. A hard cutoff means any borrower with a score below that level will be disqualified for a loan. A soft cutoff means the borrower might be disqualified, unless there are sufficient positive factors to offset the low score (such as a large down payment).

Through the Home Buying Institute, our parent website, we once conducted a survey of mortgage lenders on this very subject. Based on their responses, the average minimum score requirement was 620. Some were willing to go down to 600, if the borrower was otherwise well-qualified. Others set the bar even higher at 640.

So, while there is currently no credit-score requirement written into the qualified mortgage rules, they are still important.