Low mortgage interest rates have created a great opportunity for many homeowners to refinance their mortgages, resulting in lower monthly payments or extra cash to pay off debts.
But what about people who have low credit scores and may have trouble qualifying for a new loan? We asked Roslyn Lash, an accredited financial counselor at Youth Smart Financial Education Services and a member of NerdWallet’s Ask an Advisor network, for tips on what consumers can do if they would like to refinance their mortgages but don’t have sparkling credit.
What can people with bad credit do to take advantage of low interest rates?
The options are limited. The 2008 housing crisis was a result of exceptions where loans were provided to clients that otherwise could not afford or qualify for a loan. The loans usually had inflated rates or were otherwise predatory. Since then, lending standards have tightened up considerably.
You may not be totally out of luck, though. The Federal Housing Administration has programs for people with less-than-desirable credit that include mortgage interest rates lower than that of conventional loans. To qualify, the applicant’s overall credit history must not consistently reflect late payments or delinquencies. Therefore, someone with judgments or delinquent federal loans such as tax liens and student loans may not qualify. A low credit score resulting from periodic delinquencies or a collection could still qualify, however.
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What are the potential disadvantages of this option?
FHA loans require an Upfront Mortgage Insurance Premium. This amount is equal to 1.75% of the loan amount. In addition, a monthly mortgage insurance premium must be paid as well. The amount of the monthly premium will depend on the loan amount. When applying for an FHA loan, ask questions regarding the conditions in which these premiums can be reduced, refunded or canceled. For people already paying a monthly mortgage insurance premium, it’s possible that a refinance may actually eliminate it.
Are there any other steps people can take to improve their chances of being approved?
It’s important to show patterns of good credit, even if there are some negative marks on your credit record. A few delinquencies can be explained and won’t necessarily destroy your chances, especially if they are due to temporary drops in income or rate adjustments that increased your payment. In fact, even a bankruptcy will not automatically disqualify applicants. That being said, it’s important to re-establish your credit by having as many good lines of credit as possible.
It’s also important to minimize your debt and to be sure that your mortgage is affordable (no more than 30% of your income). An even better way to calculate affordability is to take into account not just housing debt but all debt — that means housing debt including mortgage, insurance, taxes and homeowners dues plus monthly debts such as credit cards and car payments. Using this kind of analysis, your overall debt should be no more than 43% of your gross income.
For example, if your monthly income is $2,850 and your monthly debt (including mortgage) is $1,150, you would still be in good shape to afford a mortgage, because your overall debt-to-income ratio is 40.35% ($1,150/$2,850). Please note that qualifying ratios are subject to change, and you should check with your lender.