Mortgages

How To Refinance A Mortgage With Bad Credit

Refinancing your home when you have bad credit is not only possible, it is also less risky than making a new purchase. Learn what your options are to help rebuild your credit score.

How To Refinance A Mortgage With Bad Credit

Refinancing a mortgage could help homeowners secure a lower interest rate, reduce their monthly mortgage payments, or tap into their home equity. If you have bad credit and have had trouble getting loans in the past, you may wonder if it’s possible for you to refinance your mortgage. 

Can You Refinance With Bad Credit?

Yes, it’s possible to refinance a mortgage with bad credit, and it is less risky than purchasing a new home. However, depending on a homeowner’s credit score, the process may require more legwork. Let’s take a look at what refinancing is and what kinds of scores lenders might consider “bad credit.”

What Refinancing Is and How It Works

Refinancing a mortgage means replacing an existing home loan with a new one. The new loan may have different terms, such as a lower interest rate. The process of refinancing a mortgage is similar to the process of getting a mortgage for a new home purchase. 

There are many situations when refinancing a mortgage could be beneficial. You may be interested in refinancing if you want to:

  • Lower your interest rate to reduce your monthly mortgage payments
  • Shorten your loan term to pay your home off sooner
  • Tap into your home equity to pay for home repairs or renovations
  • Remove private mortgage insurance (PMI)
  • Buy out an ex-spouse or other co-borrower

Because the refinancing process is similar to the process for taking out a mortgage on a new home, lenders may consider factors such as income, assets, and debt levels, and may ask to see supporting documentation. Lenders also look at borrowers’ credit histories.

What Counts as Bad Credit?

Credit scores are 3-digit numbers that are calculated based on a borrower’s financial history. These scores generally range from 300 to 850, and a score of 670 or higher is considered good. However, many people have lower scores.

The FICO Score, a widely-used credit scoring model, groups borrowers into 5 tiers based on their credit scores. Here’s what each range means:

  • 300-579: Poor
  • 580-669: Fair
  • 670-739: Good
  • 740-799: Very Good
  • 800-850: Exceptional

Lenders may classify scores of less than 670 — the “poor” and “fair” tiers — as subprime. For borrowers, this classification matters because people with subprime credit scores may need to work a bit harder to get new credit. Knowing your credit score could help you understand your eligibility for certain refinancing options. 

Having a low credit score is not an uncommon problem. According to a 2021 analysis from Experian, a credit reporting company, nearly ⅓ of American consumers have scores under 670. Among these consumers, the average credit score was 586. The size of this market means there are a number of refinancing options for people with lower scores.

Your Options For Refinancing Your House With Bad Credit

A low credit score isn’t necessarily an obstacle when it comes to refinancing a home. Your current lender may be able to help you refinance. Other options may include FHA refinancing, cash-out refinancing, VA streamline refinancing, and USDA streamlined assist refinancing. 

Your Current Lender

Borrowers who want to refinance their mortgage with bad credit may want to start with their current lender. Some lenders may be prepared to offer more flexible underwriting to existing customers who have low credit scores because they the lender can more easily verify the customer’s past mortgage payment history.

One solution lenders may offer is a portfolio refinance loan. This is a type of mortgage that’s kept in the lender’s books rather than being resold on the secondary market. What this means for borrowers is that lenders can choose to set different standards, such as agreeing to refinance mortgages with bad credit.

For customers who may not be eligible for refinancing, lenders may be able to offer specific advice about getting approved in the future. This advice may vary depending on a borrower’s credit score and the lender’s underwriting requirements. For example, lenders may suggest steps such as paying down debt or waiting to build more equity in the home.

FHA Refinancing

The Federal Housing Administration (FHA) is an agency that insures mortgages for homebuyers who may not be eligible for conventional loans. It offers two refinancing options.

  • FHA rate-and-term: An FHA rate-and-term refinance may be an option for borrowers who currently have a non-FHA home loan, such as a conventional mortgage. This type of loan could help borrowers change their interest rate, term length, or both. The standard credit requirement for an FHA loan is 580, but for homeowners who have 10% equity or more, this can go as low as 500. In the third quarter of 2021, the average credit score for borrowers who refinanced from a conventional to an FHA loan was 660.
  • FHA streamline: An FHA streamline refinance may be an option for borrowers who currently have an FHA loan. It’s called a streamline refinance because it requires limited paperwork. Like the FHA rate-and-term refinance, a streamline refinance could help borrowers change their interest rates and/or term lengths. The FHA may not require underwriting or a credit check for streamline refinances. However, it does require that refinances provide a tangible benefit to the borrower, such as a lower interest rate or a shorter term.

Cash-out Refinancing

Cash-out refinancing may be an option for homeowners who’ve built up equity in their homes. When you cash-out refinance, you take out a new loan for more than your current mortgage balance and take the difference in cash. 

This option could help homeowners consolidate high-interest debts into a convenient lower-interest payment. This could be beneficial because paying down your debts may help improve your credit score. A cash out refinance with bad credit could be available for borrowers with a score of 580 or higher.

However, it is not without risk. Cash-out refinances are more expensive than rate-and-term refinancing, and it is higher risk because you pull equity out of your home. But paying off your debts with equity from your home with a cash-out refinance can reduce your monthly liabilities, which would help increase your credit score over time.

VA Streamline Refinancing

VA loans are mortgages offered through the U.S. Department of Veterans Affairs. A VA streamline refinance, also known as an interest rate reduction refinancing loan (IRRRL), lets homeowners replace an existing VA-backed home loan with a new one. Streamline refinancing works with an existing insured mortgage so there is not as much documentation and underwriting needed, thereby “streamlining” the process.

People with VA home loans could use the IRRRL option to get a lower interest rate and lower their monthly mortgage payments. It could also be used to move from a variable to a fixed-rate mortgage for predictable monthly payments.

While the VA doesn’t set a minimum credit score for refinancing, credit guidelines may vary from one lender to another. Generally, borrowers can qualify for a VA loan with a score of 620 or higher.

USDA Streamlined Assist Refinancing

The United States Department of Agriculture (USDA) backs mortgages for eligible rural homebuyers. Homeowners who have an existing USDA direct or guaranteed home loan could refinance using the streamlined assist refinance option. 

The USDA doesn’t require a credit review for streamlined refinances, making it a good option for borrowers with low credit scores. However, to be eligible for a streamlined refinance, borrowers must have made on-time payments on their current loans for the previous 12 months.

How to Improve Your Credit Score For More (and Better) Options

While there are many ways to refinance a mortgage with a bad credit score, working to improve your credit score could help you access more options. Understanding how credit scores are calculated could help you take steps to improve your credit, such as paying down debt or avoiding late payments.

The FICO Score is the industry standard credit score. The company notes its score is used in 90% of lending decisions. There are 5 factors that go into a borrower’s FICO Score, each with its own weight in the scoring algorithm:

  • Payment history (35%): Your track record of payment on your credit accounts.
  • Amounts owed (30%): How much debt you carry and the percentage of your available credit you’re using.
  • Length of credit history (15%): How long you’ve had credit accounts, including the age of your oldest account.
  • Credit mix (10%): The types of accounts you have, such as credit cards, car loans, and mortgage loans.
  • New credit (10%): How many new accounts you have. 

Some lenders may use the VantageScore model when you apply for a refinance. This lesser-known credit score uses similar data points as the FICO Score, but the categories are weighted a bit differently. 

Pay Down Your Debts to Reduce Your Credit Usage

About 30% of a borrower’s FICO Score is based on the amounts they owe. Since this category is heavily weighted, paying down debt could have a significant impact on a person’s credit score. 

The FICO Score algorithm considers both the total amount of debt a borrower has and the percentage of available credit that they’re using. For example, if you have $10,000 in available credit across 3 credit cards, and your total balances add up to $4,000, your credit utilization is 40%. As a general rule, a credit utilization ratio of below 30% is considered good. 

Paying down debts could have a noticeable impact on your credit score. Reducing the balances on revolving accounts (like credit cards) by just 25% could increase a borrower’s FICO Score by up to 56 points, depending on their credit history and current score. 

Some people may consider opening new credit accounts to improve their credit utilization. Note that new credit makes up about 10% of the FICO Score, so opening multiple new accounts could drop your score.

Avoid Late Fees

A borrower’s payment history accounts for about 35% of their FICO Score. This includes their record of paying credit card bills, installment loans, and other types of accounts on time. It also includes details about late or missed payments. 

Missing 1 payment by just 30 days can reduce a borrower’s credit score by up to 83 points, depending on their credit history and current score. To reduce the risk of missing a payment and accruing late fees, consider the following strategies:

  • Track payment due dates on a calendar
  • Sign up for payment reminder emails or texts
  • Set up automatic bill payments

Consolidate Your Debts

Consolidating debts means taking out a new loan to pay for multiple existing loans. This could benefit your credit score, but there are some potential pitfalls to consider before consolidating. 

Debt consolidation may be used to combine credit cards, car loans, medical bills, or other types of debt into a single loan. Since the money is owed to a single creditor, the process of debt repayment may be simpler. Plus, if the new loan has a lower interest rate than the old ones, borrowers may save money over time. 

The credit mix makes up about 10% of the FICO Score, so if you hold limited types of credit products, adding a personal loan for debt consolidation could have a positive effect on your credit score. 

However, there are some pitfalls to keep in mind. Borrowers with low credit scores may not qualify for low-interest rate consolidation loans, so potential savings may be limited. And since consolidating debt doesn’t address the financial habits that led to the original debts, some borrowers may continue to take on debt.

Things to Consider When Refinancing With Bad Credit

For some borrowers, refinancing a mortgage with bad credit may be a good financial decision. For others, it may make more sense to wait and refinance later with a higher credit score. When deciding which option is right for you, consider:

  • The options available to you: Evaluate the refinancing options available to you and decide if any meet your needs. If not, you may prefer to wait and work on your credit.
  • Your reasons for refinancing: If you have an urgent reason to refinance, you may choose to go ahead and refinance with bad credit.
  • Your credit history: Negative marks generally stay on your credit report for 7 years. If a late payment is due to come off your report soon, waiting could make sense.

It’s possible to refinance a house with bad credit, but whether or not that’s a good decision could vary depending on individual circumstances. Talk to your financial advisor to find out if refinancing your mortgage with bad credit could help you reach your financial goals.