Learn How to Refinance Your Mortgage with Bad Credit

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Bad credit can make refinancing a home loan harder, but it’s far from a disqualifier.

According to credit rating agency Experian, “bad credit” is a score of 669 or below on a FICO score range of 300-850. If you’re in this category, you may find it difficult to get approved for credit or pay higher interest rates and fees when you do get a loan.

Homeowners in this situation often worry that refinancing a mortgage is not an option. But while it’s true you might not qualify for the best terms and rates, you still have options.

Refinancing isn’t always a good idea. It’s a big financial decision. But if it’s right for you, here are some tips for refinancing with bad credit and a look at why you might want to wait until your credit score improves.

How to refinance when you have bad credit

Step #1: Know your credit score

The first step to refinancing with bad credit is knowing exactly what your credit score is. While you might see a FICO score on your credit card statement or receive a score from credit monitoring websites, lenders use particular versions of your FICO score to make lending decisions.

The best way to access the credit scores used by mortgage lenders is to order your credit reports and FICO scores from all three national credit bureaus: Experian, TransUnion and Equifax. You can get a free report from each agency once per year.

You may find that you have a different credit score at each of the three credit bureaus. In this case, you can get an idea of the score the lender will use by using the middle of the three scores. For example, if you have a 590 from Experian, a 600 with TransUnion and a 620 with Equifax, the middle score of 600 will likely be used.

With your actual credit score in hand, you may have more options than you think. FHA loans are available to borrowers with scores as low as 500, while conventional loans backed by Fannie Mae could be obtained by those with credit scores as low as 620.

Step #2: Consider compensating factors

Even if your credit score has taken a beating, you may be able to overcome a weak credit score if you have compensating factors.

These are strengths in your financial profile that can be used to offset weaknesses. The U.S. Department of Housing and Urban Development lists factors that could make a loan underwriter willing to overlook a low credit score.

  • Housing expense payments. You’ve made on-time rent or mortgage payments greater than or equal to the proposed loan payment for your refinanced mortgage for the past 12 to 24 months.
  • Down payment. You can make a larger down payment toward the new loan. The FHA guidelines require a down payment of 10% or more for borrowers with credit scores between 500 and 579.
  • Accumulated savings. You’ve demonstrated the ability to save money and use credit sparingly.
  • Additional income. When underwriting a loan, FHA lenders use a borrower’s “effective income” to decide whether the borrower will be able to repay the mortgage. Effective income is income that is verifiable, stable and continuous. It includes things like salaries and wages, retirement benefits or social security payments, commissions, alimony or child support, notes receivable, interest and dividends, VA benefits, and rental income. If you receive government assistance, such as unemployment or Supplemental Nutrition Assistance Program benefits that are not included in effective income because they’re not expected to continue for at least three years, these forms of income can be counted as a compensating factor.
  • Minimal housing expense increase. The monthly payment for your refinanced loan will increase minimally over the mortgage payment you’re currently paying.
  • Substantial cash reserves. You will have at least three months of loan payments in cash available after closing.
  • Substantial non-taxable income. Non-taxable income may include: a portion of Social Security benefits; some federal government employee retirement income; Railroad Retirement benefits; some state government retirement income; certain types of disability and public assistance payments; child support; and military allowances. The lender may consider the tax savings from these types as part of your gross income.
  • The potential for increased earnings. If you have the potential to improve your earnings through job training or education, the lender may consider this as a compensating factor.

With an FHA loan, higher income and lower monthly debt payments will usually help you qualify despite a low credit score, said Jesse Gonzales, president of North Bay Capital in Santa Rosa, Calif.

Step #3: Talk to a licensed loan originator

It’s important to work with a trained, licensed loan originator who can assist you in navigating credit challenges when refinancing, said Richard Tucker, senior vice president of loan operations at Waterstone Mortgage. The loan originator can help you review and interpret your credit report if you’re not sure which accounts are negatively impacting your credit score.

“Every situation is different,” Tucker said, “so a licensed loan originator should be able to review and provide advice on how someone can overcome a low credit score.”

Step #4: Shop around for the best offer

When you’re worried that bad credit may prevent you from getting approved for refinancing, you may think you should just accept the first offer a lender is willing to make — but that can be a costly mistake.

According to the Consumer Financial Protection Bureau, nearly half of all mortgage borrowers don’t shop around for mortgages, but those who do compare offers from multiple lenders may see a substantial difference in rates — so talk to two or three lenders who will provide you with a detailed loan estimate so you can compare fees and interest rates.

Why you might consider waiting

Maybe you’ve heard interest rates are rising and feel like now is the time to refinance. However, you might be better off waiting until you can improve your credit score or one of your compensating factors.

The Loan Savings Calculator at the FICO website can give you an idea of how your credit score impacts the interest rate you’ll pay on a loan.

Let’s say you currently have a credit score of 620. According to the loan calculator (at time of writing), with that credit score, on a 30-year fixed rate loan for $250,000, you might be eligible for an APR of 5.905%. Here’s how much you could save if you put some effort into raising your credit score.

Credit Score APR Monthly Payment Total Interest Paid Savings over 30 Year Loan
620 5.905% $1,484 $284,111
640 5.359% $1,397 $253,077 $31,034
660 4.929% $1,331 $229,242 $54,869
680 4.715% $1,299 $217,586 $66,525

As you can see from the table above, lifting your score from 620 to 680 could result in savings of more than $66,000 in interest and fees over the life of a 30-year mortgage.

According to Gonzales, the decision to refinance now with a lower credit score or wait until you can improve your credit comes down to why you need the loan. For example, if you need a cash-out refinance to pay for critical home repairs, your situation might favor refinancing now rather than waiting. “But in general,” Gonzales said, “the best practice is to work on getting your score higher so you can qualify for the best loan with the lowest rate.”

The bottom line

If your credit has taken a hit since you first bought your house, it may be difficult to refinance. However, you’re not without options. Just make sure you analyze the cost of refinancing and compare offers available to you now versus the potential costs savings if you work on improving your score over the next few months to a year. There’s always room for improvement, which can help you qualify for a better rate, even if it takes a little time.

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