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I Pay My Mortgage On Time but I Have Bad Credit. Can I Refinance?

Q: Our credit has been bad for the past 6 years. We have 6 years left on our mortgage and have never been late. Can we refinance our mortgage?

A: Thanks for reaching out to me on AskTheMoneyCoach.com. You didn’t specify what your credit score is, but since you said you have “bad” credit, I will assume your FICO score is below 620.

If this is the case, even though you have bad credit, you may still be able to refinance your home loan. While your credit score is obviously an important element during a refinance, so are 4 other factors: the lender you choose, the type of mortgage you seek, the amount of equity in your home, and your overall financial picture.

Concerning each one of the factors, here’s what you need to know: 

The Lender

It’s important to know that some commercial lenders are more strict than others. For example, Chase and Wells Fargo are generally considered more fiscally conservative lender. So those banks tend to mainly approve borrowers with higher credit scores and stronger overall finances.

That’s not to say that someone with less-than-perfect credit can’t get approved at Chase or Wells. But such a borrower may have to jump through other hoops or have strong compensating factors to offset a so-so credit profile.

Other lenders may be more forgiving on the credit front. But the tradeoff is that you’ll definitely pay a higher interest rate to get your refinance approved.

Your Mortgage Type

This may be among the most important factors. If your credit is really bad — in the mid-500s or lower – then a conventional mortgage loan will likely prove nearly impossible to obtain, especially if you are on shaky ground with the other factors I mentioned. Under such circumstances, the type of loan you seek is crucial.

For those with poor credit, government-insured loans, such as an FHA loan, are far more feasible to get for a home purchase or home refinance, mainly because FHA loans are DTI or debt-to-income based, as opposed to credit based.

Technically, FHA doesn’t impose minimum credit score requirements at all. But remember, the Federal Housing Administration is merely guaranteeing, or insuring, FHA loans. They’re not making home loans. So here’s where some confusion comes in.

Lenders who are making FHA loans do, in fact, impose their own credit score requirements. Typically, most FHA lenders require a credit score of at least 580. Some will require a minimum credit score of 620, depending on the type of mortgage you want.

The Equity in Your Home

No conventional mortgage lender wants to loan against a property for which the value is questionable. So most conventional lenders will want you to have anywhere from 10% to 20% equity in your home for a refinance.

You can find lenders outside this spectrum, of course. For example, a handful of small or local lenders may do refinancings where the loan-to-value is 95% — meaning there is only 5% equity in the property. But these lenders will be in the minority.

Likewise, some large lenders may require 25% to 30% equity in a home before approving a refinance. The point to know is that the more equity you have in your home, the more options you have for refinancing your home loan.

If a conventional mortgage is impossible to get done, again, an FHA loan may be a solution. A current homeowner can have as little as 3.5% equity in a home and still get an FHA loan. (Ditto for a person buying a home with an FHA loan; only a 3.5% down payment is required).

Your Financial Picture

That matters greatly as well. Even though you said you haven’t been late on your home loan, since you indicated that your credit is “bad,” I assume you’ve been late with other bills – such as credit card debts or student loan payments. This will give many lenders pause.

But perhaps you can allay a lender’s fears about approving your refinance if you have an otherwise solid financial profile. Some factors that would weigh in your favor would be:

job stability (i.e. you’ve been at the same job for at least 2 or 3 years and/or you’ve been working in the same career/industry for a long time);

savings (you have a decent amount of savings tucked away, which shows that you have some financial discipline.)

A healthy level of savings is crucial for two reasons. First, you have to have sufficient cash on hand to be able to close your loan. And despite so-called “no cost” refinancings there’s always some money to pay during a refinance. Additionally, many lenders will want you to show cash “reserves” or funds on hand after your loan closes. It’s not uncommon for a lender to want you to have anywhere from 1 to 3 months worth of mortgage payments in the bank as cash “reserves” subsequent to your loan closing.

low debt to income ratio (Banks have long looked at borrowers’ outstanding debts versus their income to see if mortgage applicants could afford a loan. And although each bank has a different standard, generally the lower your debt-to-income ratio, the greater your chances of securing a home loan).

Starting in January 2014, however, the vast majority of banks have begun to adhere to guidelines imposed by the federal government to ensure that lenders avoid making risky loans. New regulations concerning so-called “qualified mortgages” or “QM” are now in effect.

One aspect of QM loans is that they are governed by something called an “ability to repay” rule,” which requires lenders to examine a person’s income, debts, savings and assets to be sure that the borrower can really pay back a home loan. With QM loans, a borrower’s total debt load (including the person’s mortgage) can’t exceed 43% of his or her income.

There are exceptions to the QM standards though, for government insured loans – like FHA loans and home loans backed by Fannie Mae or Freddie Mac. Lenders can also choose to make “non-QM” loans; those loans simply won’t be afforded certain protections against lawsuits if the loans later go bad.

As you can see, there are many considerations to take into account when you want to get a home loan. Credit is important. But it’s not everything.

To improve your chances of getting a refinance, you should certainly work on improving your credit rating. But do pay attention to each of the other factors mentioned above as well. Good luck!

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