Can You Refinance With Bad Credit?

·8 min read

If your credit score is lackluster, you may worry that it could prevent you from refinancing your mortgage. Luckily, a refinance can be difficult but not impossible. Here's what you need to know about how to refinance your mortgage with bad credit.

[Read: Best Mortgage Refinance Lenders.]

What Credit Score Do You Need to Refinance a Mortgage?

When it comes to the minimum credit score to refinance, "all institutions have different lending criteria based on the different loan programs," says Catherine Okoroh, vice president of mortgage lending at Guaranteed Rate.

In the wake of the coronavirus pandemic, Okoroh says, many lenders are raising eligibility standards to cut their risk.

Mortgage lenders typically look for a credit score of at least 620 to refinance conventional loans, but standards are more flexible with government-sponsored mortgages. For instance, lenders may approve a rate-and-term Federal Housing Administration refinance with a credit score of 580 or even skip the credit check for an FHA streamline loan.

Loans backed by the Department of Veterans Affairs have no minimum credit score requirement, but the VA requires the lender to review your entire loan profile. Applicants for U.S. Department of Agriculture loans with credit scores below 640 will be subject to manual underwriting, a process to evaluate your ability to repay a loan.

How to Refinance Your Mortgage With Bad Credit

If you're trying to refinance a mortgage with bad credit, first check your credit score to make sure it falls into that category. A FICO score between 300 and 579 is considered poor, and scores between 580 and 669 are fair. Once you know your score, you can prepare your finances and apply for the right mortgage program.

Here are some tips to keep in mind with bad credit:

Check your debt-to-income ratio, or DTI ratio, which is the percentage of your monthly income that goes toward debt.

"If a borrower has a lower credit score, their DTI also has to be lower," Okoroh says. "Typically on a conventional loan, you want the DTI to be under 45%, and for an FHA loan, the DTI should be under 50%."

Higher DTIs may be accepted for some refinance programs, though.

Boost your cash reserves. Showing a lender that you have cash on hand to cover the mortgage during financial emergencies may strengthen your refinance application. Experts recommend keeping an emergency fund of at least three to six months of your typical expenses.

Shop around with different lenders. Get rate quotes that rely on soft inquiries, which won't harm your credit. Also, ask about fees and closing costs you might pay, which can help you figure out whether to move forward with the lender.

Seek advice based on your situation. Lenders can suggest loan programs and provide tips that may improve your credit score quickly, says Andrina Valdes, chief operating officer of Cornerstone Home Lending Inc. They will "likely have specific guidance for you if your credit score needs some TLC," she says.

Rate shop within a 45-day window. Consider applying with at least three lenders to compare costs and get the best rate, even with bad credit. Multiple mortgage applications within a period of two to six weeks will count as just one hard inquiry.

[Read: Best VA Loans.]

Options for Refinancing Your Mortgage With Bad Credit

Here are some options to explore for refinancing with bad credit. Eligibility usually depends on who owns your mortgage and whether you meet the requirements.

FHA rate-and-term refinance. You may be able to do a rate-and-term FHA refinance with a credit score of 500 to 580, but those loans can be hard to access. That's because you have to find an FHA-approved lender, and lenders can add their own guidelines to the FHA's rules.

FHA streamline refinance. If your credit score is on the low side and you've had an FHA mortgage for at least 210 days, you may be able to refinance through the streamline program. Streamline refinances are available in credit-qualifying and noncredit-qualifying options.

The difference between the two is that the lender can approve the noncredit-qualifying loan without a credit check or home appraisal. You will need to show you've made six consecutive mortgage payments.

USDA streamlined assist refinance. Eligible homeowners can refinance USDA loans without a credit check, DTI evaluation or home inspection. Applicants must be current on mortgage payments the 12 months before refinancing.

VA IRRRL. If you have a VA-backed home loan, you may be able to reduce your monthly mortgage payments through this streamline program. Loans typically don't require a credit check or appraisal, and you can refinance up to 100% of your outstanding loan balance. You'll need to show you've had the loan for at least 210 days and made six consecutive monthly payments.

Fannie Mae's RefiNow or Freddie Mac's Refi Possible. These programs were developed to help low-income homeowners refinance more easily. Fannie Mae or Freddie Mac will need to own your loan to qualify, and you must meet income, DTI ratio, payment history and loan-to-value ratio requirements. However, the minimum credit score of 620 might put some borrowers out of the running.

Talk with your current lender. Explain your situation and ask about refinancing options for bad credit. You may be offered a portfolio refinance loan, a mortgage the lender originates and retains instead of selling on the secondary market. Lenders can set their own approval standards for these mortgages and may be more flexible with credit score requirements.

Should You Refinance With Bad Credit?

You will need to consider what you want out of the refinance and whether you can meet that goal to determine whether the refinance is a good idea.

"With how low rates currently are -- soon projected to start rising -- it could be a good idea to refinance now, even with bad credit," Valdes says. "But if you can take the time to improve your credit over the next several months, then do it."

Before you apply to refinance your mortgage, ask yourself these questions:

What do you want to accomplish? Before contacting a lender, "you need to know why you're refinancing," Okoroh says. "If it's to save money, you need to have a realistic range in mind, and ask the lender what that would take."

Others might be refinancing to tap home equity, change loan terms or drop private mortgage insurance. Weigh the benefits against the drawbacks of mortgage refinancing, such as paying closing costs and potentially spending more interest over the long term.

What interest rate will you receive? Even if you can refinance a mortgage with bad credit, whether you should is another matter. Borrowers with lower credit scores often receive higher interest rates compared with their excellent credit counterparts. But mortgage experts say refinancing can be a good idea if it will lower your interest rate by at least three-quarters of a percentage point.

What are the upfront costs? Refinance loans come with closing costs, typically somewhere between 3% and 6% of the loan amount. You can roll the closing costs into your loan if you can't pay in cash or seek a no-closing-cost refinance. Lenders can charge a higher rate to recover their costs, though, and this can cut into your savings.

What's the break-even point? Divide your closing costs by the amount you expect to save every month to figure out how long you will need to recoup the upfront costs of the loan. If you pay $5,000 to refinance and save $100 a month, then you will reach breakeven in 50 months.

Should you delay the refinance? "Refinancing is not for everyone," Okoroh says. If a refinance won't help you reach your goals or it would drastically increase your mortgage payments, you might consider hitting the pause button on your home loan search.

Ask a loan officer to run different scenarios, Okoroh says. Maybe you will find out that if you raise your credit score 50 points, then you can qualify for an interest rate that helps you save money. The loan officer can also use software to estimate how various financial decisions may help or hurt your credit score and chances of qualifying.

[Read: Best FHA Loans.]

How Can You Improve Your Credit to Refinance

If you decide to delay your refinance, you may be able to raise a low credit score by taking these steps:

-- Paying your bills on time. This is the biggest factor that can influence your credit score.

-- Reducing your debt. Try to use no more than 30% of the available credit on your credit cards, and pay off student loans and car loans if possible.

-- Pulling your credit reports from AnnualCreditReport.com. You can access each report online weekly for free through April 2022. Look for inaccuracies and instances of fraud, which could pull down your credit score. Dispute errors with the credit reporting agencies.

-- Becoming an authorized user. Ask someone with a strong credit history, such as a family member or trusted friend, to add you to a credit card account.

-- Avoid applying for credit, which could raise questions about your financial stability.

-- Keeping credit card accounts open to maintain the length of your credit history.