Homeowners with financial trouble wanting to refinance their mortgages to better refinance rates may be pleased to know there are still options out there for them. There are strategies available to help overcome challenges such as inadequate income, excessive debt, negative equity or poor credit.
The challenges aren’t imaginary. Lenders have indeed tightened their standards, and there are few good solutions to common problems, according to Robert Satrick, president of Prime Financial Services in Van Nuys, Calif., and chairman of the California Mortgage Bankers Association in Sacramento.
“That sounds harsh. I know that,” he says. “But that’s the reality of the way it is.”
Problem: inadequate or negative equity
The most common problem is a lack of equity, which lenders measure as a component of your loan-to-value, or LTV, ratio. If you refinanced your original mortgage to take out cash, bought your home without a down payment, obtained an interest-only or payment-option mortgage, or if your property has declined significantly in value, you may be among the homeowners who are most likely to encounter this problem.
The typical LTV ratio most lenders require today is 80 percent, though there may be some flexibility in that figure, and some government-sponsored loan programs are more generous. You can use Bankrate’s handy calculator to find out how your home’s value stacks up against your mortgage loan.
Solution: reduction of principal
One strategy to overcome this problem is to lower your loan amount, so your LTV will fall within the guidelines, says Jim Linnane, senior vice president of Wells Fargo Home Mortgage in Chicago.
That can be accomplished through a lump-sum payment, a gradual reduction of principal or both. A lump sum can be applied from a savings or retirement account, sale of another asset, income tax refund or bonus while a gradual reduction in principal can be achieved through biweekly payments or extra payments applied to principal, Linnane suggests.
“If you can apply $300, $400 or $500 a month toward your principal over a period of time, that’s not only lowering your principal, but it’s also lowering the interest that’s being charged on your outstanding principal, so you are accelerating your principal reduction even faster,” he says.
You’ll have to forgo any income that might have been earned from that extra money, so your goal should be not just to refinance your mortgage, but also to achieve a “better overall financial situation,” says Peter Thompson, a senior loan officer with Professional Mortgage Partners in Downers Grove, Ill.
If your mortgage is insured by the Federal Housing Administration or FHA, you might be able to qualify for a so-called “streamlined” refinance that doesn’t require an appraisal. More information about this program can be found on the U.S. Department of Urban Development’s Web site.
If your mortgage is owned or guaranteed by Fannie Mae or Freddie Mac and you haven’t been more than 20 days late on any of your payments in the last 12 months, you might be able to refinance with an LTV up to 105 percent through the federal government’s Making Home Affordable program. More information about this program and a questionnaire that might help you figure out whether you’ll be able to qualify can be found on the government’s Web site , FinancialStability.gov.
Mortgage insurance, which protects the lender from loss if you default on your loan, also may be a way to overcome insufficient equity. The catch is that you’ll have to pay mortgage insurance premiums and that could negate the benefits of the refinance. You’ll need to do the math to figure out whether this tradeoff makes sense for you.
If you have a second loan and the lender refuses to subordinate, you might want to combine both of your loans into one new loan. If you obtained your second loan through the same lender as your first and as part of your purchase-money financing, you may be in a better position to combine the two loans than if you obtained your second loan later on. In that case, you’ll be subject to more strict guidelines because your refinance will be considered a cash-out, rather than a conventional rate-and-term refinance. Either way, this two-for-one strategy “will be the best option for many people” even though “the guidelines may be a little more restrictive,” Linnane says. If your second loan is an untapped line of credit, the simplest solution may be to have it closed.
Problem: inadequate income or excessive debt
Income and debt are two sides of the same coin because lenders use both factors to calculate your debt-to-income, or DTI, ratio. This ratio is important because lenders want to feel confident that you earn enough income to keep up your mortgage payments. If you’ve suffered a loss of income, overstated your income on your original loan application, are self-employed or have taken on additional new debts, you’re most likely to be among the many homeowners who face this type of problem.
The DTI ratio is essentially “about affordability,” Satrick says: “Either they can afford it or they can’t.” If you’re in the latter group, you might be able to obtain relief through a loan modification instead of a refinance.
Lenders typically look for a DTI ratio that’s no more than 38 percent (your debt is no more than 38 percent of your income); however, DTI is a complicated issue and lenders’ guidelines vary, so it’s a good idea to discuss your situation with a loan officer.
Solution: Earn more, pay off debt
The most obvious solution to a troublesome DTI ratio is to earn more income through a better-paying job, pay raise or second job. Your second job must be a stable permanent position since most lenders require a two-year track record before they’ll count that income toward your DTI ratio, Thompson explains.
If you can qualify for an FHA-insured loan, you might be able to add a non-occupant cosigner to your loan application, Thompson adds. Be aware that the cosigner’s debts as well as his or her income will be counted along with yours.
Another option may be to document additional sources of income. Rents, annual bonuses, limited partnership payouts and the like can strengthen your DTI ratio, if you’re “willing to go through the challenge of explaining and documenting” that income, Linnane says.
“I would encourage people to consider that what they may think might be impossible to explain or difficult to explain maybe wouldn’t be so impossible or difficult,” he says.
On the flip side, paying off debts also can be a good strategy to refinance, even if savings are sacrificed to the cause.
“Maybe you owe $5,000 on a car loan, and you have $6,000 of discretionary cash in the bank. In this case, you could pay off the car loan to eliminate that payment and eliminate the problem,” Linnane says.
Some borrowers may want to focus on short-term installment loans, which have a fixed term, since some lenders will exclude an installment loan that has fewer than 10 payments remaining from the DTI ratio, Thompson suggests.
Problem: Credit score is too low
Your credit score is a function of your credit history, which tracks how well you’ve handled your financial obligations. Lenders are concerned about your credit score because they want to make sure you’re financially responsible enough to repay your loan. While a poor credit history was often overlooked when home prices were on the rise, lenders rarely grant such leeway to credit-impaired borrowers today. You may be offered financing, but the interest rate likely won’t be “low enough to make it attractive to refinance,” Thompson says.
Solution: Pay bills on time
There are two ways to overcome a poor credit score. One is to improve your score over time. The other is to challenge any factually erroneous information in your credit report that may adversely affect your score. Neither solution is a quick fix, but as Thompson says, “you can change a lot in six months.”