Your Guide to Refinancing a Mortgage With Bad Credit

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A borrower's goal when refinancing a mortgage is often to get a lower interest rate, especially if market conditions have led to reduced rates overall since you first took out a home loan. But you might be looking for something other than reducing your interest rate—for example, to cash out a portion of your equity, to switch to a fixed-rate loan, or to get a shorter loan term.

To refinance a mortgage with bad credit, it's best to consider your options, but it could mean lenders are less likely to offer you a competitive interest rate. There are several courses of action for borrowers with lower credit scores, especially if you qualify for specific programs offered by the federal government.

Here's what you need to know when exploring refinancing with a poor or fair credit score.

What Credit Score Do You Need to Refinance a Mortgage?

Credit requirements vary by lender and type of mortgage. In general, you'll need a credit score of 620 or higher for a conventional mortgage refinance. Certain government programs require a credit score of 580, however, or have no minimum at all.

As is true for other types of loans, the higher your credit score, the more likely a mortgage refinance lender will be to work with you. Not only are your chances of approval higher, but you'll typically receive a lower interest rate and more favorable loan terms than qualifying borrowers with lower scores.

Beyond credit score, it's also worth evaluating whether you have the funds to pay the closing costs and fees associated with refinancing, including any prepayment penalties your original lender may charge. You'll typically need at least 20% equity in your property to refinance, too, meaning you've made enough headway on your mortgage to own a portion of the home.

Lenders will also look at your debt-to-income ratio (DTI), or your total monthly debt payments compared with your income. It's ideal for your debt obligations to be no more than 36% of your monthly earnings, though some lenders will accept a higher amount.

Options for Refinancing a Mortgage With Bad Credit

If your credit score falls under the 620 threshold, you may not be able to compare offers from multiple conventional lenders, but you still have options:

  1. Apply through your current lender. Let your mortgage lender know you're interested in a refinance. It might be more likely to work with you to keep your business, and it might be more willing to take into account factors other than credit score. But you'd also be smart to shop around and compare rates from other sources, and let your lender know you're exploring or have received other offers.
  2. Choose an FHA refinance option. The Federal Housing Administration (FHA) provides multiple mortgage refinancing programs for those with lower credit scores. They include:
    • FHA streamline refinance: As its name implies, this process allows you to refinance an FHA loan with less paperwork than a typical refinance, as long as you've made 12 on-time mortgage payments. It will typically result in a lower mortgage payment.
    • FHA rate-and-term refinance: You can refinance a conventional loan into an FHA loan, but you won't be eligible for the streamlined process, and you'll need to supply income and credit verification. You also must be able to demonstrate 12 months of on-time mortgage payments.
    • FHA cash-out refinance: This option allows you to get a new home loan larger than your previous loan, plus cash for the difference. To qualify you'll need at least 20% equity in your home and a history of on-time payments for 12 months—or for the length of the loan term so far, if it's shorter than that.
  3. Look into a VA interest rate reduction refinance loan. If you currently have a home loan from the U.S. Department of Veterans Affairs, known as a VA loan, you can refinance it without undergoing a credit underwriting process or a home appraisal. You could also avoid paying out-of-pocket fees, since they can be rolled into the cost of the loan. The agency recommends comparing rates from multiple lenders before moving forward.
  4. Consider a USDA streamline refinance. Current homeowners with mortgages from the U.S. Department of Agriculture can refinance their USDA loans even if they have no or low equity. Similar to an FHA loan refinance, you're not required to undergo a credit review, but you must show 12 months of on-time payments. You must also meet income eligibility requirements.
  5. Apply for a cash-out refinance: A conventional cash-out refinance is typically easier to get for borrowers with poor or fair credit than a traditional refinance. That's partly because the lender that issues your new loan has the ability to seize your home as collateral if you default on the mortgage. Be wary of closing costs and private mortgage insurance, however, which you may have to pay if your loan is 80% or more of the home's value. These costs could negate or reduce the value of the refinance.

How to Improve Your Credit to Qualify for a Mortgage Refinance

When you're considering refinancing a mortgage, there are multiple ways to get your application in the best shape possible—both in terms of your credit score and other factors.

  • First, it's best if you can demonstrate that you have stable and sufficient income to cover your new mortgage payments. While lenders typically want to see that your debt payments do not exceed 36% of your monthly income, that limit could reach 50% in some circumstances. You may strengthen your candidacy for a refinance by paying down credit card or student loan balances before shopping for a new home loan to reduce your DTI.
  • Your application will also benefit from your ability to show cash reserves. Experts recommend keeping an emergency fund of at least three to six months of your average expenses. While this can help you stay afloat in a crisis such as job loss, it also proves to lenders that you're able to establish and maintain a savings fund, which can cover mortgage payments in a pinch.
  • You can also consider adding a cosigner to the refinance application, though it's important to make sure they understand they'll be required to make payments if you can't. The cosigner must also have strong enough credit to boost your approval odds. On the flip side, if you have a cosigner on your current mortgage and their credit score has fallen since you first got the loan, you could remove them and try to qualify for a refinance on your own.
  • Finally, work on improving your credit, which can only help your chances of refinancing. This includes not only paying down balances, but putting bill payments on autopay so you never miss one. Particularly before applying for a home loan, avoid getting other types of new credit, which could result in a hard inquiry on your credit report. Hard inquiries negatively affect your credit score for a short time, but it might make enough of a difference to affect your approval chances or the interest rate you receive.

The Bottom Line

Bad credit doesn't have to stop you from pursuing a mortgage refinance, especially if you're able to take advantage of a government program through the FHA, USDA or VA.

But carefully consider the costs of either a traditional or cash-out refinance once you've received offers. When you refinance, you should be able to enjoy a lower interest rate, monthly payment or a more stable fixed rate, if that was your goal. The costs of refinancing a mortgage with bad credit could offset those savings, so be sure you're clear on the fine print before agreeing to a lender's offer.