Refinancing a Mortgage with Bad Credit in 2023

You may have heard that a refinance can save you money but how are you supposed to refinance when you have bad credit? Can you realistically expect to find a lender to refinance your mortgage? Even if you have a good reason for the shaky state of your finances — perhaps you incurred an unexpected medical expense or a sudden layoff — refinancing with bad credit will be more challenging for you than for someone with a good credit rating.

The process of getting approved for a refinance involves scrutiny of your credit-worthiness, just as it did when you originally applied for your current mortgage. Your mortgage lender will conduct a thorough review of your finances to determine if you continue to pose a good risk. Although you passed the underwriting test the first time, this time around your lender will focus on your current finances as well as your credit history over the past several years.

Sources: Annual reports for FHA, VA, Fannie Mae, Freddie Mac, and May 2015 Ellie Mae Origination Insight Report

Your lender's primary tool for predicting your financial behavior is a close look at your financial past. That means the analysis of your credit history plays an integral part in its decision whether to approve your refinance application. Understanding what affects your credit and what goes into a credit score is essential to navigating the refinance process, particularly if you have bad credit.

Your credit score changes based on your credit activity and behavior. Each time you pay a bill to a vendor, it records the transaction. At regular intervals, the vendor passes along your record to a consumer reporting agency (CRA). The CRAs accumulate a detailed record of your credit history and create a score of credit-worthiness based on your behavior. Vendors and lenders use CRAs and the credit scores they produce to determine not only whether to provide you with credit but also how much interest to charge.

The three largest national credit bureaus are Equifax, Experian and TransUnion. For each check on your credit status, credit bureaus charge a fee. The federal government, however, requires that the credit bureaus provide access to one free report each year. You can request your no-cost credit report on a dedicated website created by the three main bureaus to satisfy the government's requirement.

Many companies offer credit scores. Lenders rely on FICO scores. Pay attention to your FICO score, and use the other credit scores brands as a ballpark guess of your FICO score.

FICO scores range from 300 to 850. The higher your FICO score, the better your credit. Put another way, the higher your score, the less risk lenders see in you, and consequently, will tend to offer you a lower interest rate. The lower your score, however, the riskier lenders will perceive you to be. A person with a low score will pay higher interest rates than a person with similar finances but a higher score.

There is no industry standard for FICO score categories. In reports to Congress, the FHA places applicants into these five FICO score ranges:

According to Fair Isaac Corp., the median score has held relatively steady at 711 over the last few years. Approximately 37 percent of consumers have excellent credit scores of 720-850.

FICO scores are weighted. Different elements of your credit history carry varying degrees of importance. FICO determines your score based on:

Overall, the higher your credit score, the greater likelihood that a lender will refinance your mortgage. Even better, you will earn a lower interest rate and pay less money over the term of your refinanced mortgage.

A lower score means that even if you are able to secure a loan or credit, you'll likely pay for your past financial missteps with a higher interest rate. Fair Isaac Corp., the FICO score creator, estimates bad credit will add 1.5 percentage points to your rate as compared to otherwise identical customers with high credit scores. Is refinancing with bad credit impossible? No. Difficult? Yes. As you might expect, a successful outcome for a bad credit refinance requires a clear set of goals, some work and a little luck.

Fair Isaac Corp. and the credit reporting agencies don't explain credit scoring very well, and leave out many significant details when they do talk about their services. Here are a few facts no one in the credit score and credit history business will tell consumers.

Now that you understand how credit scoring works and you know your credit score, you should have a reasonable idea of your chances of finding a lender to refinance your mortgage. Now is the time to improve your odds of a successful application and a lower rate.

Let's say you have a credit card bill listed as a late payment that, in fact, was paid on time. Perhaps you find a derogatory entry that is more than seven years old. Most derogatories older than seven years should not appear on your credit report. A common error is a derogatory account that is not yours. You pay for credit history mistakes with a lower credit score, higher interest payments or even loan denials. Clearing up incorrect derogatories on your record can only help you. Here's what you can do to address the inaccuracies:

If you're reluctant to wait and want to proceed with a refinance with bad credit, explore the available financing options. The Federal Housing Administration (FHA) offers two refinancing programs, and there are other government programs that may help as well.

One type of FHA refinance, in which the mortgage loan is insured by the FHA, allows homeowners with bad credit to refinance into mortgages with lower interest rates or different terms. Unlike the typical refinancing process of conventional loans, the FHA refinance's credit history requirements are less strict. For instance, to qualify for the FHA's 3.5 percent down payment program you can have a FICO score as low as 580. Even if your score falls below 580, you can still participate in an FHA refinance with a 10 percent down payment.

Although the FHA creates the guidelines for FHA loans, which they insure, the FHA is not the one lending the money. Your FHA approved mortgage lender provides the funds. This is a critical point to note because your mortgage lender may dictate tighter standards than those set by the FHA. In fact, many participating FHA approved lenders require a FICO score of at least 620 and at least two years of on-time payments and proactive management of your finances before they will agree to extend a loan through the FHA refinance program.

Another FHA program that may be available to homeowners with bad credit is the FHA Streamline loan program. This program requires that you already have an FHA mortgage. For homeowners with bad credit, the FHA Streamline program may prove a great fit: It doesn't require a credit check or minimum credit score. In addition, unlike almost any other mortgage product, an FHA Streamline loan approval process doesn't require other verifications typical of a standard mortgage approval process, including verification of income or employment.

Another advantage of the streamline program is that it does not require a fresh appraisal of your property. The FHA allows you to use your original purchase price as the home's current value. With this waiver, a loan applicant can benefit greatly if area home prices have risen, because the important loan-to-value (LTV) ratio swings in the homeowner's favor.

If you are a veteran, you may be able to refinance through the U.S. Department of Veterans Affairs' (VA) Streamline Refinance, officially known as the VA Interest Rate Reduction Refinance Loan (IRRRL). You need to meet a number of qualifications to be eligible for a VA Streamline Refinance.

The requirements include:

• Certification you occupy the property.
• Proof your current loan is based on your VA loan eligibility.
• Documentation of up-to-date on payments for your current VA loan, with no more than one 30-day late payment within the past 12 months.
• A refinance that lowers your monthly payment — unless you are switching from an adjustable rate to a fixed-rate mortgage.

The VA Streamline can be designed with closing costs rolled into the loan, which would allow you to refinance without any upfront out-of-pocket costs. The program does not allow a cash-out option, although other VA loan programs do.

Now that you have an understanding of the ways bad credit affects your financial opportunities, including the process of seeking out a refinance and getting approved for a mortgage, you can explore your options with confidence. You can choose to wait and work on debt reduction and pull yourself out of bad credit. Or you can take advantage of a government refinance program that is more forgiving of bad credit. No matter what decision you make, you have resources at hand to help you along the way.