Mortgage refinance options for borrowers with bad credit
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After a year dominated by continual mortgage rate increases, the pendulum has begun to swing in the opposite direction: Rates are slowly declining. As of early February, rates on a 30-year-mortgage had dropped to 6.3 percent. Though that’s nowhere near the rock bottom 3 percent rates that were common just a few years ago, it’s still a notable drop from rates that were in excess of 7 percent in late 2022. And they’re expected to hold steady for a while: skyrocketing rises seem to be over, at least for now.
If you’re hoping to refinance in order to switch from an adjustable rate mortgage to a fixed rate mortgage or you want to tap into home equity, the environment is growing more favorable. For those who have bad credit however, even the most recent round of rate decreases may not be all that helpful. With subpar credit, you’re still likely to be charged a steep interest rate in order to refinance. But there are ways to cope.
Can you refinance your mortgage with bad credit?
The first thing you need to do when considering refinancing is to know your credit score and to understand what mortgage lenders are looking for in a borrower’s refinance application.
In general, a credit score of between 670 and 739 is considered good; scores between 580 and 669 are considered fair and anything below 580 is considered poor. When it comes to the credit score needed to refinance, 620 tends to be the minimum for a conventional loan. FHA refinances are possible if your credit score is as low as the mid-500s.
Your credit score is important to lenders because it provides an indication of how likely you are to repay a loan in a timely, reliable fashion. An applicant with a lower credit score represents a greater risk for lenders. Lenders will seek to mitigate that risk by charging you a steeper interest rate.
These concerns of lenders exist no matter where interest rates are (though of course the higher the rate, the more crucial your financial soundness becomes). If a lender approves your refinance application, they’re likely to require that you pay a steep interest rate on the loan. It is important to note, however, that there are lenders who work with borrowers with lower credit scores as outlined below.
Options to refinance your mortgage with low credit score
1. Try your own mortgage lender first
Mortgage lenders focus on forming relationships with borrowers. If you’re trying to refinance but have bad credit, you’ll need to spend some time finding an option that works for your unique financial picture. This effort should start with your current lender or loan servicer since you are already their customer.
If your mortgage is with a financial institution, contact the officer or employee you dealt with originally, if they are still there. If not, “get a referral to a specific person,” advises Leslie Tayne, a financial debt resolution attorney with Tayne Law Group and author of “Life & Debt.” “Having the name of someone and something in common like the referral source is an excellent way to start building the relationship. Explain your needs and find out the options the bank can offer to you.”
What you really want is the benefit of the doubt. If a lender looks at your debt-to-income ratio (DTI) and your loan-to-value ratio (LTV), as well as other factors, and your application is in a gray zone, it can go either way. You want a “yes” — and if you have a relationship with the lender, perhaps even having checking or savings accounts with them, then maybe that will be in your favor.
“Communicate often and be prepared with the [financials] the bank will be requesting to back up your request for funding,” says Tayne. “Being organized and responsive is vital. The banker will appreciate you helping him/her do their job better, which is to put the loan together for underwriting.”
Banks that will refinance with bad credit
If you have low credit and are hoping to refinance your mortgage, don’t despair. There are low credit score mortgage lenders who will work with you. This includes mortgage companies, online lenders and well-known traditional brick and mortar banks such as U.S. Bank that work with borrowers who have subpar credit.
If you’re interested in refinancing, it’s important to dedicate some time to researching the various offers and options. And as you’re shopping around pay particular attention to the interest rates and APRs that each lender is offering for individuals with low credit scores.
2. Check out an FHA streamline refinance
If you want to refinance and you have an FHA loan, the FHA streamline refinance program can be a great option. The average credit score for a borrower who refinanced an FHA loan between October and December of 2021 was 657, according to the U.S. Department of Housing and Urban Development, with the minimum credit score to refinance of 580. However, borrowers with credit scores as low as 500 but with home equity of 10 percent or more may be approved for refinancing.
Characteristics of the FHA streamline refinance program:
- Limited paperwork requirements.You don’t need a lot of new paperwork, since streamline refinancing requires limited borrower credit documentation and underwriting. What the lender must have is evidence that your most recent six consecutive mortgage payments were paid on time and in full.
- Mortgage insurance premium refund. If you refinance within three years of when your current FHA loan closed, you might be able to get some of your upfront mortgage insurance premium refunded. This can help offset the cost of refinancing.
- Net tangible benefits. The refinance must produce a “net tangible benefit,” such as a 5 percent reduction in your monthly mortgage payment or a change from adjustable-rate financing to a fixed-rate loan.
- Limited cash out. Cash in excess of $500 may not be taken out on mortgages refinanced under this program. The main benefit of this option is to permanently lower your monthly payments.
3. Explore an FHA rate-and-term refinance
While an FHA streamline refinance is reserved for current FHA borrowers, any borrower can apply for an FHA rate-and-term refinance — and if your mortgage has a high interest rate, it might well benefit you to do so. There is more paperwork involved in this process – a new appraisal and a credit check most likely will be required and the mortgage being refinanced must be current for the month due.
Like the streamline program, an FHA rate-and-term refinance is not a cash-out program — the purpose is to help you reduce your monthly housing costs. All proceeds must be used to pay your existing mortgage and costs associated with the transaction. However this method allows second and third mortgages to be included in the refinanced amount.
4. Apply for a VA streamline refinance or a VA-backed cash-out refinance loan
If you have an existing VA- backed home loan, you can refinance even with bad credit with a no-hassle Interest Rate Reduction Refinance Loan (IRRRL), also known as a VA streamline refinance. IRRRLs typically require that you provide financial information such as two years of W-2s and federal income tax returns as well as recent paystubs. Lenders who offer this option will also require a home appraisal.
“The VA has updated IRRRL guidelines in recent years, with a focus on ensuring the refinance makes financial sense for qualifying veterans,” says Chris Birk, director of education at Veterans United Home Loans. “Homeowners will need a minimum amount of ‘seasoning’ on their current loan in order to be eligible for an IRRRL. That typically means you must have made at least six monthly mortgage payments, although some lenders have even more stringent seasoning guidelines.”
Like an FHA streamline refinance, an IRRRL must result in a “net tangible benefit” for the borrower.
“VA homeowners must be able to recoup the costs of the new loan within 36 months of closing,” says Birk, author of “The Book on VA Loans: An Essential Guide to Maximizing Your Home Loan Benefits.” “Those costs do not include the VA funding fee or escrows.”
If you are a veteran with a current mortgage that is not a VA loan, a VA-backed cash out refinance loan lets you replace your current loan with a new one while allowing you to take cash out of your home equity. Even if you do not want to take cash out, eligible veterans with a current mortgage from a lender other than the VA should investigate this option to refinance through this program.
5. Use the USDA Streamlined Assist program
If you’re eligible, the USDA’s Streamlined Assist program can be the ideal option for a refinance with bad credit because there’s no credit review required. Instead, anyone with a loan through the USDA or backed by the USDA who has made the last 12 months’ worth of mortgage payments on time can qualify.
In addition to no credit check, this program also doesn’t require a new home appraisal or home inspection and doesn’t consider your debt-to-income ratio when determining your eligibility. Like other streamline programs, there must be a certain minimum outcome – in this case at least a $50 net reduction in the monthly mortgage payment.
6. Consider a portfolio refinance loan
Another refinance option if you have bad credit is a portfolio loan. You can obtain a portfolio loan — so called because it’s held (and oftentimes serviced) by the original lender rather than being sold to other entities — through banks and mortgage brokers, who set their own standards for the loan, which can be more flexible than typical refinance requirements. You’re more likely to get a portfolio loan if you’ve been a long-time bank or mortgage customer or the lender wants your business.
That doesn’t mean lenders will finance any borrower regardless of qualifications, however. They still want portfolio loans to perform, and that means they will take a careful look at your finances and credit history. If you’ve had an application issue that has not passed muster with most lenders, a portfolio lender could be more open.
According to Tayne, some portfolio lenders “cater to smaller borrowers because it’s their specialty or primary customer base, and they’re looking to build their portfolios of small lending. Smaller borrowers typically have the potential for growth, and the more money a business is making, the more money the lender is making.”
To find out if a portfolio loan is available to you, work with a mortgage broker or a full-service mortgage lender who can shop your application to portfolio lenders.
7. Find a co-signer
If bad credit is preventing you from refinancing and locking in a lower rate, there is one strategy that can quickly change your situation: getting a co-signer/co-borrower.
A co-signer with strong credit and deeper pockets gives the lender more security, but even among family or friends, co-signing a mortgage is a business deal. Co-signers worked to get their money and credit, so you’ll have to convince them that you have the financial capacity to repay the loan, and that you’ll put repayment of the loan first before other obligations.
Delinquencies (late payments) go against both borrowers’ credit reports and if the loan were to go unpaid, the co-signer is then responsible, and the lender will look to them for any shortfall.
Some difficult questions will also have to be answered. Is the co-signer also a co-owner of the property? What happens in the event of divorce, death or a simple falling-out? Both parties should have wills, living wills and any other paperwork needed to protect estates. Get help from an attorney to get the entire arrangement in writing, to protect both yourself and your co-signer.
Should you refinance with bad credit?
If you have bad credit, you might be wondering if you should hold off on refinancing. If you can refinance now, it’s worth consideration. Why? It might just be a critical step in helping turn that bad credit to good.
Benefits of refinancing
Shrink your payments. If refinancing can lower your monthly mortgage payment, you’ll free up more of your budget to pay off other debts or add more to your savings.
Eliminate mortgage insurance. If refinancing involves a new appraisal of your home, you could learn that your home’s value has increased. If the value has risen to the point where you now have 20 percent equity, you might be able to stop paying mortgage insurance expenses.
Save money in the long run. Deciding to refinance can save you quite a bit of money over the course of the entire loan. You can use Bankrate’s mortgage refinance calculator to estimate your savings.
Drawbacks of refinancing
While refinancing your mortgage may offer benefits, there are also costs associated with the process and you may not always obtain a better interest rate. Some of the drawbacks to consider include:
Closing costs. Similar to obtaining your initial mortgage, there are closing costs to be paid when you refinance. Depending on where in the country you live, closing costs can be quite steep, amounting to thousands of dollars out of your pocket.
Longer loan term: When you refinance you’re effectively restarting your loan repayment term and delaying your final payoff date. So you’ll be in debt longer.
Credit score impact: Mortgage lenders conduct a hard inquiry on your profile as part of reviewing your application, which causes your score to decline temporarily. This type of inquiry can decrease your score by about five points. In addition, when you refinance, you’re closing your old mortgage in order to establish the new mortgage loan. This in turn impacts your credit history, and credit history accounts for about 15 percent of your overall score.
How to improve your credit for a refinance
As you consider your options to refinance with bad credit, it’s important to think about how to improve your credit score moving forward. If none of the above refinance options work for you, it might be a good idea to take a step back, evaluate your overall financial situation and make some changes to strengthen your financial well-being:
- Start a budget: Track the money you take in and the money that goes out. When you start a budget and stick to it, you might not only find ways to reduce expenses, but also begin recognizing the little costs that are adding up.
- Check your credit report: All three major credit reporting bureaus — Experian, Equifax and TransUnion — have to provide you with at least one free credit report. You can get these free reports at AnnualCreditReport.com. While the reports won’t give your credit score, they’ll detail all your debts and your payment history, which impacts your score. When you pull your reports, look for factual errors, out-of-date info, unauthorized charges and fraud — issues like these could be lowering your score.
- Pay down bills: While you’re making a budget, create a list of all of your debts and arrange them by size. Then, target the smallest debt and work to pay it off. By doing this, you’ll have one less bill to pay, and you don’t have to worry about late fees, since it’s paid off. The money saved each month can then be used to pay down the next bill you tackle. Another good strategy is to pay off higher interest rate credit cards and/or consider a balance transfer to eliminate incurring interest fees for a stated period. This strategy helps to free up funds you can apply toward higher interest rate credit card debt – saving you money while improving your credit score.
- Save money: Help yourself, no matter how small. If you put aside $8 a week — maybe from the change you get each day —you’ll have $416 at the end of a year. Once you get into the habit of saving, you’ll likely find it gets easier with each dollar you stash away. Building up a bigger savings account can make a meaningful difference in refinancing, too, because lenders look at your cash flow and reserves. With more in savings, you’ll be a stronger candidate for a refinance.
- Reduce your credit utilization ratio: Your credit utilization ratio is the amount of your available credit across all of your credit cards and any other revolving accounts that you have: How much of your balances you’re currently using. Credit utilization accounts for a steep 30 percent of your score. Reducing utilization is an important way to improve your score.
- Pay all bills on time: The most significant factor contributing to your credit score is your payment history. It amounts to about 35 percent of your overall score. Consistently paying bills on time without fail can have a significant impact on improving your score.
Most employers allow you to direct deposit to more than one account so be sure to pay yourself first by putting some money in your savings account each pay day.
Final word on refinancing with bad credit
While refinancing can save you money, remember that it costs money, too. Be sure to account for all the costs of refinancing, even with bad credit, to make sure it’s worthwhile.