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Published: Dec 27, 2021 15 min read
A  new day  sunrise (representing the refinancing aspect) and a house positioned in the  poor credit  sun rays
Kiersten Essenpreis for Money

You may think that refinancing your mortgage if you have bad credit is out of the question. Not necessarily.

You should have options even without the best credit score. We’ve spelled out the steps you can take to refinance your home loan — regardless of your score. (That said, you may not qualify for the best interest rates and terms, so consider looking into improving your credit score.)

What exactly is a ‘bad’ credit score? Who decides?

Your credit score is a three-digit number that mortgage lenders use to measure the likelihood you’ll pay your bills. Scores range from 300 to 850 and the higher your score, the better. A score below 620 is typically considered to be bad, although each lender will decide the score needed to qualify for a mortgage.

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How to refinance a mortgage with bad credit

Preparation and patience will be key to refinancing with bad credit. Here are the steps you should take.

1. Review your credit report and check your credit score

To figure out your best option, you’ll need to check your credit report. Your credit score will be based on the information contained in this report.

Credit reports contain data about your credit history, such as whether you make payments on time and when you last took on new debt. Review the report and identify incorrect information. Getting those items removed can improve your score.

You can request a report from any one of the three credit reporting agencies — Experian, Equifax and Transunion. Typically you would be able to obtain one free credit report from each of the agencies per year, but as part of the measures put in place to protect consumers during the pandemic, you can request a free credit report on a weekly basis until April 2022.

After reviewing your report, you’ll want to check your credit score. Sites like Credit Karma will provide your score for free. Many credit card providers now offer access to your score as well.

2. Get familiar with your financial situation and loan options

Next, evaluate your finances to determine what you can reasonably afford and qualify for.

Be sure you know what type of loan you have now. Refinancing into the same type of loan is an option but not the only one. It pays to look at different loan categories that may be more credit friendly. Keep in mind, however, that some refinancing options for those with poor credit are limited to certain borrowers. USDA refinances, for example, are only available to those who already have a USDA mortgage.

You also want to know your current interest rate. This will allow you to compare the new rates lenders are offering and determine if the difference is enough to help you achieve your refi goals or whether it’s best to wait and work on improving your credit.

Look at your payment history and make sure there aren’t gaps. Most lenders will require a minimum of 6 to 12 months of on-time mortgage payments to approve a refinance loan. Late or missed payments can hurt your chances of approval.

Consider different types of loans. Check out a glossary of refinance options available to people with low credit scores at the end of this story.

3. Build your savings

There are costs associated with refinancing your loan. You’ll have to pay closing costs which can total between 3% and 6% of the loan amount.

Having a nest egg can also show the lender that you have enough saved to cover your mortgage payments in case of a setback. Most lenders look for enough savings to cover six months of living expenses.

4. Shop around for the best rate and terms

Start by checking with your current lender. They may be willing to work with you to obtain a better rate. However, don’t limit yourself. Check with several different lenders to find the best rates and terms, including online lenders and credit unions. On average, borrowers who request a rate quote from more than one lender save between $600 and $1,200 over the life of the loan, according to Freddie Mac.

5. Consider applying with a co-signer

Another option is to apply with a co-signer who has a better credit score. Lenders will average your credit scores and consider both parties’ income and assets when underwriting the loan.

This option does come with some caveats. Your co-signer will be responsible for paying the mortgage if you can no longer meet your obligations, so make sure you can afford the new payments. Some lenders may also require the co-signer to be added onto the title of the property even if they don’t live there.

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When does refinancing with bad credit make sense?

There are a few reasons why refinancing could make sense despite having less than perfect credit.

1. Your credit score/finances have improved

If your score has increased (even if it’s still not stellar) or your financial position has improved from the time when you closed on your mortgage, a refinance may reduce your interest rate and monthly payment.

In a recent study by home investment start-up Haus, borrowers who were able to increase their credit score from below 649 to between 650 and 699 saw a 0.16 percentage point decrease in the interest rate offered by lenders. Increasing the score to between 700 and 749 netted a 0.42 percentage point decrease in rate.

While you still may not qualify for the lowest rates, many experts point out that if you can reduce your interest rate by at least 0.5 percentage points, it might be a good time to refinance.

Before taking that step, however, be sure you understand all the costs involved and what your break-even point is, or how long it will take to recover your refinancing costs. You want to make sure you’ll benefit and not make your situation worse.

2. You’ve built up 20% equity in your home

One of the benefits of FHA loans is that they only require 3.5% down. However, you are required to pay a mortgage insurance premium over the full term of the loan. Once you’ve reached 20% equity in your home, you may be able to refinance into a conventional loan and eliminate the FHA insurance premium, which typically costs 1.75% of the loan amount.

3. You want to change your loan term or type of mortgage

You may have originally opted for a 15-year fixed-rate mortgage but are now struggling with the higher monthly payments. Refinancing into a 30-year mortgage may lower your monthly payment. Another reason may be to change from an adjustable-rate mortgage to a fixed-rate mortgage, which will provide greater stability in terms of the monthly payment.

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Common bad credit refinancing options

The following are the most common rate and term refinancing options for borrowers with bad credit.

FHA loans

An advantage of refinancing into a Federal Housing Administration-backed loan is that borrowers with credit scores as low as 500 are eligible. There are several options to consider:

- FHA streamline refinance

A streamline refinance is only available to homeowners who already have an FHA loan.

A streamline refinance must provide the homeowner with a tangible benefit, such as:

  • a decrease of at least 0.5 percentage points in the interest rate
  • refinancing an adjustable-rate mortgage into a fixed-rate loan
  • shortening the loan term from 30 to 15 years to pay the loan off faster (in this case, the monthly payment cannot increase by more than $50 and the new interest rate must be lower than the current rate).

Qualification requirements include the ability to pay upfront closing costs (fees can run between 3% and 6% of the loan amount), no late payments in the last 6 months and no more than one late payment in the last 12 months.

For most borrowers with bad credit, the Non-Credit Qualifying loan will make the most sense. This loan doesn’t require a credit check, employment verification or home appraisal and the underwriting process and documentation required are streamlined to speed up the process.

Homeowners with as little as 2.5% equity can refinance as long as they have a credit score of at least 580. If your credit score is between 500 and 579, you’ll need at least 10% equity.

- FHA rate and term refinance

Homeowners with a conventional mortgage can refinance into an FHA loan, although not with a streamlined process. This means that the lender will require a hard credit check, proof of income and a home appraisal. The credit score requirements, however, are the same as for a streamline refi.

Conventional loans

There are some conventional mortgage lenders who are willing to work with borrowers with low credit scores. Exactly how low will depend on the lender. Most will require a score of at least 620 to approve a refi loan. Some lenders may also require you to have at least 20% equity in your home.

These lenders will also look at your debt-to-income ratio. Ideally, your monthly DTI should be 36% but some lenders will accept DTIs of 43% or higher in some cases. A history of on-time payments, enough savings to cover closing costs plus six months of monthly payments can also help your chances of approval.

There are lenders who will accept credit scores lower than 620, but the tradeoff may be a higher interest rate, not a lower one. If your goal is to reduce your rate, it may be better to wait until your score improves.

VA refinance loans

The Department of Veteran Affairs isn’t a mortgage lender but will guarantee loans provided by private lenders. VA refinance loans are available to active duty and retired members of the armed forces, veterans, and surviving spouses of eligible service members even if your current mortgage is not a VA loan.

The VA doesn’t require a minimum credit score. Instead, each lender will set its own minimums. A credit score of at least 620 is a common requirement. VA loans also don’t require a down payment. There are two types of refinance loans backed by the VA.

- Interest Rate Reduction Refinance Loan

This loan is only available if you are refinancing an existing VA loan and can be used to either reduce your interest rate or convert an adjustable-rate mortgage into a fixed-rate loan in order to obtain a predictable monthly payment. This loan is also known as a ‘streamline refinance’ because it requires less paperwork than usual and can be obtained quicker.

- VA cash-out loan

Despite the name, you do not actually have to take cash out with this type of loan. The advantage of a VA cash-out loan is that you can refinance either an existing VA loan or conventional mortgage into a VA loan and qualify for a lower interest rate. You have the option of taking equity out of your home in the form of cash.

USDA Refinance Loans

There are a number of refinance options for borrowers in rural areas who currently have a mortgage through the U.S. Department of Agriculture. In general, the USDA doesn’t have a minimum credit score requirement, but lenders will typically ask for a score of at least 640.

USDA refinance loans must be fixed-rate 30-year loans and the interest rate cannot exceed the rate on the loan being refinanced. You don’t need to have a certain amount of equity in the home to refinance.

While there are options for those who plan to build or repair a home, we’ll concentrate on the three options for borrowers with an existing primary residence. Each of these requires that the home be a primary residence, and the owner must have made on-time mortgage payments for the last six to 12 months, depending on the type of refinance.

- USDA streamlined-assist refinance

This is the most common type of USDA refinance loan. It doesn’t require a credit review or appraisal. You do need to have made the last 12 mortgage payments without any late payments. With this option, however, you do need to prove a tangible benefit of reducing your monthly mortgage payments, including taxes and interest, by at least $50 per month in order to qualify.

- USDA streamlined refinance

As the name implies, the streamlined refinance is designed to make the refinancing process easier. To qualify, you need to have made on-time payments for the last six months. In most situations, the USDA does not require a home appraisal or a home inspection, although your lender might. A full credit review will be required by the lender. The new loan doesn’t have to provide a tangible benefit.

- USDA non-streamlined refinance

This option is identical to applying for a mortgage. A home appraisal and full credit review by the lender will be required, you must provide income documentation and bank statements and you must have made on-time payments on your current mortgage for the previous six months.

More from Money:

How to Get a Mortgage With Bad Credit

7 Steps to Improve Your Credit Score Right Now

Is Now a Good Time to Refinance Your Mortgage?