How to Refinance a Mortgage with Bad Credit
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Mortgage rates hit a record new low—dipping under 3% for the first time in 50 years. Home prices continue to rise despite the pandemic.
Seems like the perfect time to refinance a home, right?
For homeowners with bad credit scores, it’s another story. Refinance lenders, swamped with requests and reckoning with deep economic uncertainty, are ratcheting up their standards and effectively shutting out everyone but those with the best credit, according to industry experts.
People with weak credit scores have been “totally locked out” of these new opportunities to save money, says Laurie Goodman, vice president at the Urban Institute and co-director of its Housing Finance Policy Center.
“Mortgage lending standards are tightening extremely,” she says. “I mean, the contraction has just been very, very apparent.”
If your credit score is below 700, you may be wondering where that leaves you. Data and numbers from the Urban Institute show it will be increasingly difficult for those with lower credit scores to refinance in the months ahead. Here’s what to know.
Understanding How Mortgage Refinancing Works
Refinancing a mortgage is when you take out a new loan to replace your existing one. You’ll keep your current house, but you’ll have a new mortgage with new terms. The refinance process has the same procedures of getting a new house: applying for a loan, underwriting, home appraisal, and closing. Here’s why you might want to refinance your mortgage loan:
Your Options For Refinancing A Mortgage With Bad Credit
There are different requirements to qualify for a refinance — and a lower interest rate — depending on what type of loan you apply for. Many borrowers with bad credit can refinance with programs backed by the federal government or loan programs with more relaxed credit score requirements in your area. For example, South Carolina-based Peoples Bank Mortgage offers a “fresh chance” portfolio loan that allows you to get mortgage financing if your credit has been negatively impacted in the last two years.
But you also have to meet certain requirements to qualify for program support. For example, a common requirement is there must be a “net tangible benefit” for you to refinance, such as obtaining a lower rate by at least 0.5% or choosing a shorter term. If you can’t meet a program’s standards, the loan application will not go through.
It’s possible refinancing could leave you better off. Still, you should explore what refinancing options are out there and compare them closely before you decide.
Talk To Your Current Lender
You may already have a relationship with your current lender from your original mortgage. So it may be wise to speak to your lender first, explain your situation, and find out your options. Ask your lender what type of loans or programs they offer, particularly for homeowners with bad credit.
If you don’t feel good about your options with your current lender, don’t be afraid to reach out to other lenders and shop around. Not all lenders offer the same types of loans, and it’s possible one lender could be a better fit for your situation.
Choose a FHA Refinance Option
The FHA provides multiple mortgage refinancing programs for homeowners with lower credit scores. One big requirement: your mortgage must already be a FHA loan to qualify. They include:
- FHA streamline refinance: To qualify for this loan, you must have an existing FHA mortgage and be current on the payments. There are two types of FHA streamline refinance loans — credit-qualifying and non-credit-qualifying. The latter of the two doesn’t require a home appraisal, a full credit check, or take your debt-to-income ratio into consideration. But you might have to pay a slightly higher interest than if you were to refinance with a credit-qualifying loan.
- FHA rate-and-term refinance: You might benefit from this type of FHA loan if you have a high interest rate. It’s designed to help borrowers refinance their prime residences and reduce monthly housing costs. Unlike the FHA streamline refinance, a credit check and a new appraisal is required. And to qualify, you have to show you have paid six consecutive mortgage payments on time and in full.
Look Into a VA Refinance Loan
If you have an existing mortgage backed by the Department of Veterans Affairs, or VA, you can refinance with the Interest Rate Reduction Refinance Loan (IRRRL), which typically does not require a credit score or appraisal. Plus, there’s no annual cost to guarantee the loan. You can refinance up to 100% of the property’s value with a VA loan. You’ll have to go through a private bank, mortgage company or credit union to get this VA loan.
Consider a Portfolio Refinance Loan
A portfolio refinance loan is a mortgage that’s not sold through the secondary market and can only be obtained by a lender. Banks and mortgage brokers can set their own standards for this type of loan, so their standards will likely differ from typical loan requirements. Lenders will still take a good look at your finances and credit history for a portfolio refinance loan, but these loans can come with looser requirements. And lenders may be more flexible with their minimum credit score standards. Just make sure you’re not being offered an overly high interest rate in exchange for those looser standards.
What Credit Score Do You Need to Refinance?
The credit score you need to refinance boils down to one question: How do lenders define good credit, especially in the middle of a global pandemic? There isn’t a straightforward answer – but here’s a starting point for reference.
Before the pandemic, good credit was considered to be the high 600s or low 700s, according to Warren Goldberg, president and certified mortgage planning specialist at Mortgage Wealth Advisors in Plainview, New York. Now it’s moved up into the mid-700s and higher, he says.
Lenders use their own credit scoring models and view your credit score by pulling your credit history from the three major credit bureaus — Experian, TransUnion, and Equifax. You can check your credit score by visiting a free credit score website, checking with your credit card issuer, or talking to a nonprofit credit counselor.
Some homeowners have been able to refinance with credit scores in the low 600s as recently as the last few months, says Erin Griffin, a Chicago-based senior mortgage advisor at Preferred Rate, although they were mostly applying for government-backed loans. Typically, government-backed loans are easier to obtain because they protect the lender if you don’t pay back the money you borrow.
However, even some government-backed mortgage lenders are substantially raising credit score requirements during the coronavirus pandemic, though official minimums remain unchanged. For example, the Federal Housing Administration, or FHA, insures mortgages issued by lenders like banks, credit unions and nonbanks, and has its own set of requirements to qualify. But you still have to find FHA-approved lenders to access these loans, and those lenders can add extra minimums on top of what the FHA requires. Right now, official guidelines say you can get FHA refinancing with a credit score of just 580. But those loans can be hard to find in reality.
In fiscal year 2019, just 11.69% of all FHA refinance loans were made to borrowers with credit scores between 580 and 619, according to the Department of Housing and Urban Development. That’s because many lenders apply their own credit standards even if the FHA minimum allows for it.
“Anything below 600 is definitely a non-lendable area” in 2020, says Griffin. “There are some lenders that will do 580 or a little less, but that’s not normal.”
Should You Refinance Your Mortgage With Bad Credit?
Even if you technically could refinance with a credit score in the 600s, whether or not you should is another matter. “Someone with worse credit is also going to have a higher interest rate than someone with perfect credit,” Goldberg says. “If your credit is poor enough, you have to analyze the numbers to see if it’s worthwhile to proceed.”
Deciding if and when to refinance is no small decision. Even when interest rates are low, a lower credit score will lead to a higher rate, which means you’ll pay more in interest over the long term. So don’t jump on the bandwagon just because other people are doing it.
Figure out what you hope to accomplish by refinancing, whether it’s a lower monthly payment, changing your loan term, pulling equity from your home, or dropping your PMI (private mortgage insurance). You should weigh the pros and cons of mortgage refinancing and feel certain about your employment situation before moving forward.
Is It Worth The Cost?
As a general rule of thumb, refinancing is a smart idea if you can reduce your interest rate by at least 1-2%. Less money will come out of your pocket over time with a lower interest rate, and you can use your savings to build an emergency fund or pay down debt faster.
But refinancing always comes at a cost, and a lower credit score means lenders (outside of specific programs) will offer you less competitive interest rates. Plus, there are closing costs you’ll have to pay when you refinance, typically somewhere between 3-6% of the loan amount.
If you’re looking for a better rate or term by refinancing, you should consider the break-even point: the length of time it will take for you to recoup the upfront costs of refinancing. Divide your closing costs by how much you expect to save every month by refinancing to see how long the monthly savings will take to match the costs. Doing the math can help tell you if it’s worth it.
It usually takes years to break even. So if you don’t plan to stay in your home for at least a few years, the upfront costs won’t outweigh the long-term potential savings.
You can refinance your current mortgage even if you have bad credit, but that doesn’t mean it’s a smart move. A lower credit score means a higher interest rate — no matter what. So you may get stuck with a sub-par rate that’s not worth the cost of refinancing.
Tips For Improving Your Credit Score Before Refinancing
The good news: Bad credit isn’t permanent. If you can’t refinance now, Goldberg says you should focus on building your credit and improving your score. Having a good credit score is an important element of financial health, and you can raise a bad credit score fairly quickly with small actions, such as paying your bills on time or lowering your credit utilization. It’s really important to know your credit score and credit history before you refinance, so there aren’t any surprises down the line.
“Most people who have bad credit scores don’t know it,” Goldberg says.
If your credit score or financial situation hasn’t improved since your last mortgage application, take a step back and evaluate why that is. Then take some initial steps toward creating a healthier financial situation for yourself. If you don’t know where to start, see our advice on ways to improve your credit.
Four Questions to Ask Yourself Before Refinancing With Bad Credit
To set yourself up for a successful refinance, ask yourself these questions to help figure out whether or not to refinance right now:
What will refinancing accomplish?
The most common reason to refinance is to save money. Understanding what you hope to accomplish with a mortgage refinance will give you clarity on if it’s the right option for you. Refinancing is an attractive option right now for homeowners because mortgage rates are so low, but there might be other reasons why you’d like to refinance. Maybe you want to pay your mortgage off faster, lower your monthly mortgage payments, or drop your private mortgage insurance. Whatever the reason, have a good understanding of how it will benefit you in the long run.
With a low credit score, even if you manage to qualify for a refinance, you’ll likely face a higher interest rate and higher monthly payments than someone with excellent credit.
Can I cover my refinance expense and realize the long-term benefits?
There are closing costs and fees associated with refinancing a mortgage, which are typically 3-6% of a loan’s principal. Refinancing can save you money in the long-term – but there are short-term costs. Before you decide to refinance, make sure your plans will allow you to realize the long-term cost savings, otherwise the refinance could end up costing you more.
Did I shop around and do enough research on my refinance options?
Mortgage rates vary greatly — from day to day and lender to lender. You could be leaving serious money on the table if you don’t shop around and explore all your options. When you have bad credit, it may be harder to find competitive rates or favorable loan terms. To better understand your refinance options and get the best deal, start early by having conversations with different lenders.
Did I check my credit report for any red flags or errors?
Before you speak to lenders about refinancing, check your credit report for any mistakes. You can get free copies of your credit report from the three main credit reporting bureaus TransUnion, Equifax, and Experian — at annualcreditreport.com. Typically, you’re only able to access each once a year, but all three are offering free weekly credit reports online until 2021 due to the pandemic. If you come across any red flags or errors, report it immediately as it can negatively impact your eligibility for a refinance or the interest rate you qualify for.