Refinancing might seem like a perfect solution for mortgage borrowers who are facing foreclosure. A new loan with a lower mortgage interest rate or longer term might mean a more affordable payment. Or a new lender might seemingly be more willing to cooperate on a loan modification, short sale or deed-in-lieu of foreclosure.
Unfortunately for borrowers, however, it’s not easy to refinance a loan that’s headed into foreclosure or is already within the foreclosure process. Here are three reasons.
1. Negative equity. A borrower facing foreclosure typically owes more on the mortgage than the home is worth. If the home was more valuable or the loan amount was less, the borrower would be able to sell the property and avoid the foreclosure that way. Yet, most lenders require borrowers to have at least some “skin in the game” (i.e., equity) to refinance a loan.
One government program, the “short refinance” offered through the Federal Housing Administration, or FHA, has attempted to address this issue. However, the program has a long list of requirements and is voluntary for lenders, who haven’t rushed to participate in it. Some states also offer foreclosure refinance loans, though again, the requirements are often difficult for borrowers to meet.
2. Impaired credit. Borrowers facing foreclosure have, almost by definition, made one or more late payments or missed one or more payments altogether. That uneven payment history will have a negative effect on the borrower’s credit score, and a lower credit score will hinder the borrower’s ability to refinance. Most lenders require a minimum credit score to refinance a home loan.
3. Debt ratio. Borrowers facing foreclosure may not earn enough income to afford their current mortgage payment. (An exception is referred to as a strategic default, in which the borrower walks away from the property because the loan is upside-down, or more than the value of the home.) Some borrowers may be able to afford a lower payment, but a borrower who is unemployed or earns too little income relative to debt won’t be able to refinance as a way to avoid foreclosure.