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.
You can still refinance if you …
Have one 30-day late payment in the past year that is reported to the credit bureaus.
Have a low FICO credit score and qualify for a streamline refinance.
Filed for Chapter 13 bankruptcy but show on-time payments.
Marry someone with bad credit.
You will have problems refinancing if you …
Have four 30-day late payments in the past year that are reported to the credit bureaus.
Have a FICO credit score less than 680 and cannot qualify for a streamline refinance.
Filed for a Chapter 7 less than two years ago.
Max-out your credit cards.
Lose your income.
Refinance to remove co-signer from mortgage that you can’t afford on your own.
What is “Bad Credit” When Refinancing a Mortgage?
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.
Credit Score Based on Credit History
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.
- Late payments
- Short sale
- Too much credit utilization
- Too many accounts opened at the same time or nearly the same time
Your Score is Relative and Varies Over Time
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.
Information Credit Bureaus Gather
What do CRAs use to create your credit score?
They examine information showing your:
Promptness in paying off credit cards and loans.
Consistency in paying rent, utilities and other regular expenses.
Amount of outstanding debt.
Available credit on your credit cards and home equity loans.
Activity that involves opening a number of credit accounts at the same time.
Your credit history also includes other additional details about your financial history, including any foreclosure, short sale, arrest or bankruptcy filing. Even the existence of a lawsuit filed against you goes into your credit history. Any such hiccup in your credit history is called a derogatory.
Information Credit Bureaus Don’t Gather
Information that is protected by privacy and anti-discrimination laws does not factor into your credit score. The following information is not relevant to your credit history:
Your age, race, sex, religion, national origin or marital status.
Your place of residence.
Your occupation and title, employer, salary or employment history.
Any public assistance funding or support services you receive.
Any child and family support you receive or pay.
Your participation in credit counseling or use of a debt management plan.
The amount of interest you pay on credit cards or other accounts.
Although your credit score excludes these privacy-protected factors, individual lenders and vendors may supplement their knowledge of your credit-worthiness by requiring information about your age, current and past employment and other information before extending credit.
3 Largest Credit History Providers
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.
Credit Scores at a Glance
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.
5 Basic Factors in FICO Score Calculation
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.
FICO and Credit Score Must-Knows
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.
Your FICO score is not fixed. It fluctuates to reflect the ups and downs of your history of payments and loans. Credit scores are relative — your score can vary even though there have been no negative or positive changes to your credit history.
The credit bureaus do not share information and are competitors. This means your history may vary slightly, or even a great deal, from one credit reporting agency to another. Some lenders will pull information from one credit bureau, and others will pull your history from all three. How they interpret the differences from report to report varies.
A FICO score is created by Fair Isaac Corp. But not all credit scores are FICO scores. Remember this detail when you prepare for a refinance. You may see one number from one of the many FICO competitors, and your lender may see a different number because it bought a FICO-branded score.
Fair Isaac Corp. sells variations on its FICO scores that are supposedly tailored to the needs of different industries. It is possible for you to have your FICO score pulled by a mortgage lender and a car dealer at the same instant and each will see a different FICO score result.
Each lender has its own lending policy guidelines. Some rely on your credit score heavily, and others may look at the details in your history. In the lending world, this is called looking at your creditworthiness. Although one lender may deny a loan based on two late payments, another may be more lenient. Lenders also carefully consider your debt-to-income ratio, which is the amount of total debt you have compared to your total income. If your debt is more than 40 percent of your income, you are in a danger zone. If the debt is more than 50 percent of your income it is unlikely that you will find a lender willing to refinance your loan.
In recent years, FICO score alternatives have emerged. Lenders use FICO scores, but it may also include information from alternative scoring systems in assessing your credit-worthiness. The alternatives create similar results to FICO, and will give you an idea of where your score stands.
VantageScore is a scoring model developed by the three major credit bureaus (Equifax, Experian and TransUnion) as an alternative to FICO. VantageScore’s aim is to provide more consistent scores among the three bureaus and more detailed information for “subprimes” — those consumers with less-than-perfect credit. Like FICO, VantageScore is designed to assess the likelihood that you’ll consistently make your payments on time. Any deviation from that consistency will lower your score. Like FICO, Vantage credit scores range from 300-850.
Credit Karma provides no-cost credit scores from Equifax and TransUnion that are updated weekly. The online service also provides Vantage credit scores. You can access your credit score on Credit Karma once a week.
4 Steps to Qualify for a Refinance with Bad Credit
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.
Look at your credit score and history objectively. Review the infographic above, Average FICO Score for Recent Home Loan Applications, to see the FICO score you need to achieve. These numbers are not absolutes — you can qualify with a lower score if you have compensating factors that outweigh your low score. But if you are like most borrowers with a low FICO score, you need to create a plan to increase your score unless you qualify for a streamline refinance.
You may qualify for a streamline refinance — which does not require a minimum credit check — if you have an FHA, VA, or USDA loan. See the section Other Refinance Options below to learn if you qualify for an FHA Streamline loan.
What are some specific actions you can take to improve your credit score? For one, removing incorrect derogatories on your credit report is essential to boosting your FICO credit score. A close look at your credit report may reveal a surprise: One or more of the items listed as derogatories may be inaccurate. See the section How to Clean Up Your Credit History below if you find inaccurate negative items on your credit history.
If you decide to put a hold on your refinancing plans, you can improve your financial situation by driving down your credit card balances, and paying your debts on time, which will improve your score.
7 Ways to Improve Your Credit Score
Submit all payments on time.
Pay off delinquent bills.
Concentrate on paying down any credit cards that are near credit limits.
If you have seldom-used credit cards, rather than closing them out, use them carefully to create a good history.
Keep your spending under control by setting up a detailed monthly budget.
Contact creditors and request higher credit limits.
Clean up inaccurate derogatories on your credit history.
How to Clean Up Your Credit History
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:
Contact the credit reporting agency (Equifax, Experian or TransUnion) that is reporting the incorrect information and request a correction to your record. Use the online forms at Equifax, Experian or TransUnion to file a correction or send the CRAs the correction in writing.
Always inform the CRA in writing of the inaccurate information, and include copies of supporting documents, including the original bill and a copy of your canceled check or notation on your bank statement
Keep a copy of all correspondence. It helps to start a file folder of all your documents, to store them either as hard or electronic copies.
A second approach you can take is to contact your creditor directly. If you have had an on-time payment history with the creditor that is the subject of the derogatory — perhaps aside from one or two late payments a few years ago — ask it in writing to remove the derogatory entry. Remind your creditor the Fair Credit Reporting Act (FCRA) allows it to remove an entry at will. If you do not receive a positive response to your first letter, follow up with another.
Patience and persistence on your part are very important to your credit rehabilitation process.
A method of verification notice requires the CRA receiving it to verify the information in question is accurate. It is beyond the scope of this article to describe how to file a method of verification notice. Because this can be a prelude to a lawsuit against a CRA, it’s a good idea to consult with a consumer rights lawyer before sending such a notice.
Keep in mind that many online scammers offering instant credit rehabilitation prey on vulnerable individuals, so be thorough in assessing the expertise and sincerity of the attorney or professional you engage.
If the derogatories on your credit report are accurate, then your only option is to wait. Time heals all wounds when it comes to derogatories. With some patience and time, you can wait to refinance while you work on improving your credit and moving out of your bad credit status. Here is a list of derogatories shown with the number of years it takes to disappear from your credit history:
- Credit inquiries and applications 2 years
- Chapter 13 bankruptcy and unpaid court judgment 7 years
- Chapter 7 bankruptcy 10 years
- Unpaid tax lien 15 years
Other Refinance Options
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.
FHA Rate and Term
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.
FHA Streamline Loan 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.
You are required to have made at least six payments on your original FHA loan to qualify for the FHA’s Streamline program. You must also show a tangible benefit from the program’s options. Other aspects of the streamline refinance are similar to conventional FHA loans in that mortgage loans are available for 15- or 30-year terms and as fixed or adjustable rates. If you are eligible for this program, the FHA Streamline may be a superior choice and perhaps your only choice.
VA Streamline Loan or Interest Rate Reduction Refinancing Loan (IRRRL)
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.
Home Affordable Refinance Program (HARP 2.0)
If you still haven’t found a viable refinance solution, another option you may be eligible for is the federal government’s Home Affordable Refinance Program, known in its current version as HARP 2.0. HARP, designed to assist homeowners harmed by the subprime mortgage crisis, allows homeowners to refinance their loans at current low interest rates even though they may owe more on their current mortgage than their properties are worth. They are “underwater” or close to it because their home values plummeted shortly after they purchased their homes and market values may not have risen back to what they were at the time of the purchase. These homeowners have negative equity in their homes and may have trouble finding a lender willing to take on their refinance.
HARP allows homeowners with a conforming conventional loan to refinance without paying down principal or purchasing private mortgage insurance (PMI), provided they don’t already pay PMI with their current mortgage loan. The deadline for HARP is Dec. 31, 2018.
To learn if you are eligible for HARP, visit this HARP page.
Home Affordable Modification Program (HAMP)
The Home Affordable Modification Program (HAMP) is another federal government program designed to help homeowners harmed by the subprime mortgage crisis. Struggling homeowners who have loans with less favorable rates and terms can modify their loans by having lenders write down a portion of the loan, thus reducing the loan amount and the payments due on the remaining balance.
You must meet these requirements to take advantage of HAMP:
Your original loan is dated no later than Jan. 1, 2009.
Your mortgage is a first lien with a maximum unpaid principal balance of $729,750.
Your property is owner-occupied or a one-to-four unit rental property.
Your property is not condemned.
You have not been convicted of a crime connected to a mortgage or real estate transaction in the last 10 years.
The combined costs of principal, interest, property taxes and homeowner insurance payments are more than 31 percent of your gross monthly household income.
Here’s what your lender might do in the HAMP process:
1) Reduce your loan interest rate to as low as 2 percent for the first five years. After the first five years, the lender can raise the rate 1 percent a year to the prevailing rate at the time of your loan modification.
2) Extend the term of the loan to a maximum of 40 years.
3) Reduce the amount of the principal of the loan.
HAMP provides incentives for lenders who set up programs for borrowers who are current on their mortgage payments but are in imminent danger of default. The deadline for HAMP is December 31, 2016.
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.