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A Guide to Home Loans for Bad Credit

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Home Loans For Bad Credit

It may not come as a surprise that buying a home can be challenging for people who have bad credit, especially with the new median credit score required to qualify for a new mortgage slowly rising. Lenders like to see high credit scores because it exhibits the borrower’s ability to manage debt, make on-time payments and use their credit responsibly. Even though these things will come into question when a person with poor or bad credit applies for a home loan, they don’t have to let their score hold them back from homeownership.

This guide will review how bad credit can affect your ability to get approved for a home loan, available home loan options for bad credit and tips for improving your score.

PART I: Home Loan Options For Borrowers with Bad Credit

Conventional Loans for Bad Credit

 Credit Score RequiredDown payment RequiredMortgage InsuranceFees/Fine Print
FHA loans5803.5% (10% for buyers with a credit score less than 580)
RequiredUpfront mortgage insurance
Fannie Mae HomeReady®
program

620
3%Required, but can be canceled once borrower’s home equity reaches 20%
Homeownership education: $75
USDA loansNo minimum credit score0%
Required
Origination: 1-2%; Guarantee fee: 1%; Annual fee: .35%
VA loansNo minimum credit score
0%, unless specified by lender
Not requiredFunding fee varies

FHA loans

Homebuyers turn to government-backed Federal Housing Authority (FHA) loans for many reasons, particularly the low down payment and acceptance of applicants with a low credit score. There is no minimum income requirement, but lenders do want to see that the borrower can afford his or her monthly mortgage payments, if approved.

FHA loan requirements include:

  • A minimum credit score of 580
  • The property must be buyer’s primary residence
  • The property must meet standards outlined by the U.S. Department of Housing and Urban Development (HUD)
  • A down payment of 3.5%; 10% if credit score is lower than 580

If an FHA loan seems like the best option for you, the lender tool on the HUD website can help you find an FHA-approved lender.

VA loans

VA loans carry more relaxed requirements than conventional loans. Backed by the U.S. Department of Veterans Affairs, VA loans are offered to active-duty service members, veterans and their spouses who wish to purchase a condominium, a single-family home, a co-op or a manufactured home. What makes this a great choice for those with bad credit is that there is no minimum credit score or down payment required, unless specified by the lender.

VA loan requirements include:

  • A certificate of Eligibility (COE) to confirm that the buyer is a veteran or an active duty service member
  • The property must be buyer’s primary residence
  • A debt-to-income ratio (DTI) of no more than 41%

Buyers can can contact lenders directly to determine if a VA loan is an available option.

USDA loans

Created by the U.S. Department of Agriculture, USDA loans can be used to purchased property in areas defined as suburban or rural areas across the country. This option is often considered by those who will likely be denied traditional financing because of their low credit score and income. When applying for the USDA loan, applicants are not required to make a down payment, can have closing costs included in the loan and may not be required to have a minimum credit score, unless specified by the lender.

USDA loan requirements include:

  • The property must be the buyer’s primary residence
  • Positive payment history on accounts
  • A very low to moderate income
  • The property must be located in a USDA-eligible area
  • A reliable, verifiable source of income for at least the last 24 months

To find a lender who offers USDA loans, borrowers can review the recent list of approved USDA lenders or contact a specific lender directly to see if it offers this type of loan.

Fannie Mae HomeReady® program

The Fannie Mae HomeReady program is an option for first-time homebuyers as well as repeat buyers. The low down payment of 3%, which can be paid for using grants, a gift, cash-on-hand and Community Seconds® (a subordinate mortgage used in connection with a first mortgage delivered to Fannie Mae), cancellable mortgage insurance and acceptance of low credit scores make this an option to consider.

Fannie Mae HomeReady requirements include:

  • A credit score of 620 or greater
  • A low to moderate income
  • Completion of homeownership education
  • The home must be located in a low-income Census tract area

Buyers can speak to specific lenders to determine if they offer the Fannie Mae HomeReady loan.

Manufactured Home Loans For Bad Credit

Manufactured homes are built in factories then transported to a site where they are permanently affixed to a chassis. Many people who are interested in purchasing this particular type of home turn to financing to cover the cost, whether it is through a bank, credit union or the manufactured-home retailer.

As with purchasing a traditional residential property, those with bad credit have a reduced chance of getting approved for a manufactured-home loan, but there are options that are available to them.

 Credit Score Required
Down payment Required
Mortgage Insurance
Fees/Fine Print
FHA Title I
No minimum credit score
5% (10% if credit score is 500 or lower)
Required
N/A
FHA Title II5803.5% (10% if credit score is 580 or lower)
Required
N/A
Chattel Loans
Varies based on lender
Varies based on lender, but 5% is common
Varies based on lender
N/A
Fannie Mae HomeReady program
6203%Required until buyer’s home equity reaches 20%
Homeownership education: $75
USDA loansNo minimum credit score
Not requiredRequiredOrigination: 1-2%; Guarantee fee: 1%; Annual fee: .35%
VA loans
No minimum credit score
Not required, unless specified by lender
Not required
Funding fee varies

FHA

FHA loans can be used not just to purchase a manufactured home, but also the lot where the manufactured home will be located. When opting for this type of financing, there is a maximum loan amount that varies based on what you are purchasing. For example, if you are only buying a manufactured home, the loan maximum is $69,678, but if you are purchasing the home and the lot, the loan maximum is $92,904. If a buyer does not wish to purchase a lot, he or she can lease, but the lender must have an initial lease term of three years.

FHA loan requirements for the purchase of a manufactured home include:

  • The ability to cover the minimum down payment
  • The home must be used as the primary residence
  • The home’s site must meet local standards
  • Sufficient monthly income to cover cost of the mortgage
  • The home must meet the Model Manufactured Home Installation Standards.

Local manufactured-home retailers can provide borrowers with a list of lenders that offer FHA loans, or they can use the lender tool available on the HUD website.

VA

VA loans are always a great option for veterans and active duty service members who don’t have the best credit or the cash to cover a down payment. If you plan to purchase a manufactured home using a VA loan, you will encounter similar eligibility requirements as those who opt for traditional residential properties, as well as a few additional requirements.

VA loan requirements for the purchase of a manufactured home include:

  • A certificate of Eligibility (COE) from the military
  • Payment of a VA funding fee
  • The home must be affixed to a permanent foundation
  • The home must be considered real estate, rather than personal property

Conventional

Conventional loans can be used to purchase manufactured homes that will be the buyer’s primary residence or second home. The home will be used as collateral for the borrower to secure the loan, and a down payment of at least 5% is often required.

Conventional loan requirements for the purchase of a manufactured home include:

  • The buyer must own the land where the home is located
  • The home cannot have been built on or before June 15, 1976
  • The home should be at least 12 feet wide, with no fewer than 600 square feet of living space
  • The home must be connected to utilities

USDA

USDA loans can be used for the purchase of a manufactured home as well as the lot where the home will be located. Although the home is manufactured, the buyer is still expected to live in a rural area, just as those who choose to purchase a site-built home using this type of loan are.

USDA loan requirements for a manufactured home include:

  • The home must be affixed to a permanent foundation
  • Must purchase a site that is located in a rural area
  • The site must have both adequate water and sewage systems
  • If considered a single-wide, the manufactured unit must be at least 12 feet wide, with no fewer than 400 square feet of living space
  • If considered a double-wide, the manufactured unit must be at least 20 feet wide, with no fewer than 400 square feet of living space
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PART II: Ways to Clean Up Bad Credit Before Applying for a Home Loan

With your credit score heavily affecting the total cost of your loan, you’ll want to clean up your bad credit before you apply for any type of home loan. By taking several steps, you won’t just boost it, you’ll save money, too. For example, if you can increase your credit score from the 620-639 range to somewhere between 640 and 659, you can lower your APR by nearly half a percentage point and save around $70 monthly on your mortgage payments.

Tips to improve your credit score

A low credit score can hold you back from getting a home loan, but you don’t have to be stuck with your current score. If you want to improve your credit score before applying for a home loan to increase your chances of approval, there a few different things you can do.

  • Pay down existing debts: Your credit score can drop or rise based on how much debt you currently have and when you make payments. As you pay down your debt, you will increase your score.
  • Pay your bills on time: Payment history is a major part of determining your credit score, so paying your bills on time can mean a score increase.
  • Avoid applying for new credit: Applying for new credit will result in a hard inquiry on your credit report, which can cause your score to drop.
  • Keep old credit accounts open: Keep old accounts open because closing one will shorten the length of your credit history and bring down your score.
  • Address discrepancies on your credit report: It is not unheard of for people to discover inaccurate information on their credit reports, so a thorough review of your report could help you correct any discrepancies that may be bringing down your score.

Getting a mortgage after bankruptcy or foreclosure

Bankruptcy has its benefits, but when a person files, his or her credit score is likely to drop. Even after their bankruptcy has been “discharged,” releasing the debtor of his or her responsibility for the debts, the filer can expect it to remain on his or her credit report for at least seven years, and possibly up to 10.

If you have a bankruptcy filing on your credit report, before applying for a mortgage it might be better to wait until it is removed from your report and work on increasing your score in the meantime, but this not always what people decide to do.

If you choose to apply for a loan before your bankruptcy has been removed from your report, conventional loans and government-backed loans are still an option. You may have to wait a specified amount of time after the bankruptcy has been discharged, which varies based on the type of bankruptcy filed and the type of loan you plan to secure.

For example, someone who has filed a Chapter 7 liquidation will have to wait four years if he or she wants to apply for a conventional home loan. Someone who has filed for Chapter 13 will have to wait one year if he or she wants to apply for an FHA loan. If foreclosure is the cause of the bankruptcy, this can extend the waiting period. However, if the bankruptcy was due to an extenuating circumstance, such as divorce, illness or job loss, buyers may be able to get the waiting period shortened and find a lender that will work with them.

Improve your shot at approval even if you have bad credit

If your credit score is poor and you still wish to apply for a loan, there are things you can do to improve your shot at approval.

  • Put down a bigger down payment: A bigger down payment means you’ll have to borrow less money for the purchase of your home, and with a smaller loan amount, you might get approved.
  • Explain your low credit score: Certain information that appears on your credit report that drags down your score, such as a missed payment that your creditor reported, can be explained or disputed by adding a statement to your report that lenders can see when they pull your credit report.
  • Get your rent payments reported to credit bureaus: Your rent is a monthly bill that can be reported to the credit bureaus and increase your credit score, but this can only help if you have a positive payment history.
  • Decrease the loan amount: Someone with bad credit may have trouble getting approved for a $200,000 loan because it may appear to a lender that he or she can’t afford the monthly mortgage payments due to heavy debt, but if the borrower finds a less expensive home and applies for a loan for $100,000, he or she will be seen as less of a risk to the lender.

PART III: Additional resources

Renting vs. Buying

People often question whether renting or buying is the better option. When making this decision, you’ll want to look at things like your credit score, annual income and monthly expenses to determine which option is the most affordable for you at the current time. Although there are many factors to consider when deciding if you should rent or buy, if you have poor credit, continuing to rent may be the smartest move because it will give you more time to increase your score as well as your chances of getting approved for a home loan.

Watch out for scams that target low-credit homebuyers

When people are desperate to become homeowners, they can easily fall victim to scams, specifically email phishing. For many years, homebuyers have been targeted by fraudsters pretending to be their real estate or settlement agent in order to get the buyer to pay them money that was meant for their closing costs. Buyers receive an email informing them of a change that affects their closing process and how they must pay closing costs. It states that the buyer must wire the funds rather than pay closing costs using a check, but if the money is sent, the fraudster receives the cash, not the correct party.

To avoid this scam, potential homebuyers should not send any personal information or money. They should ensure they have a clear understanding of their lender’s closing process, call their real estate or settlement agent after they receive an email regarding any changes to the closing process, and request the assistance of their bank with confirming ownership of the account where they have been instructed to wire the funds.

Email phishing is not the only scam homebuyers may encounter. Some people opt for a lease-to-own homebuying experience, but this is known to lead to trouble. Often used to take advantage of low-income buyers, a lease-to-own agreement is a way for property owners to profit from the buyer’s inability to cover the cost of repairs for the home. This particular type of agreement leaves buyers unprotected, so instead of being able to get current with payments after they have fallen behind, like a buyer who has a home loan, one missed payment can result in foreclosure. Ultimately, when the home is foreclosed on, the seller is able to collect the rent and any deposits the buyer made while they lived in the home.

To avoid this scam, homebuyers should consider screening the property owner, speaking to an attorney about the agreement and getting a home inspection to reveal any repairs and their extent, which can help them to determine if they can cover the cost of repairs as well as their monthly rent.

FAQs

Yes, but buyers cannot apply for a home loan until the waiting period has lapsed.

Yes, but when refinancing, lenders will review your credit score, so if it has improved since you first applied for your bad credit home loan, you may get a better interest rate and lower monthly payment.

Yes, when applying for a home loan, borrowers can choose to have a cosigner who will be responsible for their debt should they be unable to make their monthly mortgage payments.

No, checking your credit will not cause your score to drop because it is not considered a hard inquiry, which is what can lead to a drop in score.

When one lender has denied your loan application because of a poor credit score, you can apply for a home loan with a different lender, but this can bring down your score because each application will result in a hard inquiry on your credit report. That being said, FICO considers all credit inquiries made within a 45-day period to be only one inquiry, so it may be worth it to shop around and then make a decision based on who you think is most likely to approve your application.

Because credit scores range between 300 and 850, lenders often consider a score of 580 or lower poor or bad.

Homebuyers interested in lowering their interest rate may be offered the opportunity to purchase discount points at closing. This prepaid interest allows people to make a payment — one point is 1% of their loan amount — in exchange for the lender lowering their interest rate by a set percentage amount for every point purchased.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Kristina Byas
Kristina Byas |

Kristina Byas is a writer at MagnifyMoney. You can email Kristina here

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How to Refinance Your Mortgage to Save Money and Consolidate Debt

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Happy black couple standing outside their house

Refinancing your mortgage, which is the process of paying off your existing home loan and replacing it with a new loan, can save homeowners money. But before you consider a mortgage refinance, you should understand how much it costs and what the process entails.

In this guide, we’ll explore how to refinance a mortgage, how much it costs to refinance and how to decide whether you should refinance at all. We’ll also discuss the refinancing process and offer comparison-shopping tips.

How to refinance your mortgage

Before we cover the steps you need to take to refinance a mortgage, we first need to understand the different refinance options available. Below is a table of the types of refinances and the process involved for each in refinancing your mortgage.

Types of mortgage refinances

Refinance Type

How Does It Work?

Cash-outA way to borrow against your available equity. You take out a new mortgage with a larger balance than your existing loan and pocket the difference in cash.
Limited cash-outThe refi closing costs and fees are financed into the new loan, and you may receive a small amount of cash — not to exceed 2% of the loan amount or $2,000, whichever is lower — when the closing documents are reconciled.
No cash-outAlso called “rate-and-term” refinance. You refinance your existing loan balance to improve your loan terms by securing a lower mortgage rate or switching mortgage types, for example. You can either pay your closing costs and fees out of pocket or finance them into your new loan.
StreamlineA refinance with limited documentation and underwriting requirements. The goal is to lower your monthly mortgage payment. Streamline refinances are available on government-backed mortgages through the FHA, USDA and VA.

Step-by-step guide to shopping for a mortgage refinance

Before you start shopping for a new mortgage, arm yourself with knowledge. First, check mortgage refinance rates in your area online.

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It’s good to know what the best rates are, but it’s even better to know if you’ll qualify for them. About six months before you plan on applying for a refinance, pull a copy of your credit report from each of the three major credit reporting bureaus — Equifax, Experian and TransUnion. Review your reports for accuracy and dispute any errors you find. You’ll also want to access your credit scores to see where you stand.

Aim for a score of 740 or higher to qualify for the lowest mortgage rates. You can still qualify with a lower credit score, but the lower your score, the higher your interest rate will be.

Choose your rate type
Decide which rate type works for you. For example, do you have an adjustable-rate mortgage and want to switch to a fixed-rate mortgage? Mortgage rates might be lower now, but eventually they’ll increase. If you have a 5/1 ARM, your mortgage rate is fixed for the first five years, but will adjust annually thereafter. Unless you know with certainty you can afford your monthly payments when your rate starts rising, or you aren’t planning to stay in the home for long, an ARM is risky.

If you don’t want to gamble with your monthly mortgage payment, stick with a fixed-rate mortgage. Your rate will be locked in for the life of your loan.

Gather multiple quotes

As with most shopping endeavors, the best way to find the best price is to get quotes from multiple mortgage lenders in your area.

There are two primary criteria for you to consider. The first, of course, is interest rates. The second is fees, which can eat into your savings.

It’s easy to take the path of least resistance and refinance with your current lender, which may offer you lower fees than their competitors. But the interest rates offered by your current lender may be higher than what’s available with other lenders. Get outside quotes to use as leverage for negotiations.

Or maybe your lender is offering you lower fees and interest rates than the competition, but the rate is still higher than you’d like it to be because of a less-than-perfect credit score. While doing so doesn’t have a high success rate, you can try negotiating for a lower rate based on customer loyalty.

Prepare your documents

Gather these commonly required documents before approaching your lender to ensure the application process goes as smoothly as possible:

  • Personal information: Be prepared with your Social Security number, driver’s license or other state-issued ID, and the addresses you have lived at for at least the past three years. Lenders are required to verify your identity before lending you any money or allowing you to open any type of financial account.
  • Accounting of debts: Statements for any outstanding credit card balances or loans you may have, including your current mortgage.
  • Proof of employment and income: Last two to three months’ worth of pay stubs, employer contact information, including anyone you’ve worked for in the past two years, W-2s and income tax documents for the past two years and/or additional documentation of income for the past two years for self-employed individuals, including schedules and profit/loss statements.
  • Proof of assets: A list of all the properties you own, life insurance statements, retirement account statements and bank account statements going back at least three months.
  • Proof of insurance: This generally refers to homeowners insurance and title insurance.
  • Additional documents: If you receive income from disability, Social Security, child support, alimony, rental property, regular overtime pay, consistent bonuses or a pension, be sure to provide documentation for these income sources as well.

There may be additional documents required depending on your lender, but checking off this list is a great start.

Apply for the refinance

Once you’ve done your homework and gathered all your information, apply for the refinance with the lender you’ve selected.

How long does it take to refinance a mortgage?

The full process of being approved for a mortgage refinance typically takes between 20 and 45 days if you submit your paperwork in a timely manner. It will require hard pulls of your credit reports and scores, along with the submission of personal documentation.

Approval
A loan officer will look over your paperwork, which will hopefully end in approval. You’ll then be sent documents to review. It would be wise to do so with a lawyer, which is an additional fee you’ll want to consider as part of your refinancing costs.

Closing
If everything checks out and you agree to your new loan terms, then it’s time to finalize the deal with your mortgage closing. If you didn’t finance your closing costs and fees as part of your new loan, you’ll pay for them at closing time. Depending on the lender, you’ll sign your documents in person, through postal mail or online. After the paperwork is processed, your current mortgage will be paid off and your refinanced mortgage will take effect.

Should you refinance your mortgage?

There are many reasons you might consider refinancing your mortgage. For example, interest rates could have dropped significantly since you first bought your house. You may also have a growing list of home repairs that need to be addressed, or high-interest credit card or student loan debt to consolidate, and a refinance can help you achieve those goals.

But are any of these good reasons to refi? To decide, you need to factor in the cost of refinancing a mortgage, along with some other considerations. We’ll weigh the pros and cons of refinancing for various goals below.

Refinancing to lock in a lower mortgage rate

Mortgage interest rates have been historically low for a while. As of mid-September 2019, the average interest rate on a 30-year fixed-rate mortgage was 3.56%, according to Freddie Mac’s Primary Mortgage Market Survey. During the same week in 2018, the average rate was 4.6%. If your original mortgage rate is higher than 4%, it might make sense to explore your refinance options, since a lower interest rate can save you money over time.
See the table below for an illustration of how a lower interest rate can reduce the overall cost of your mortgage.

 Existing mortgageNew mortgage

Loan amount

$290,921.36$290,921.36

Years remaining on term

28 years30 years

Interest rate

5%4%

Monthly payment
(principal and interest)


$1,610.46$1,388.90

Total interest paid
(over 30 years)


$279,767.35$209,083.75

Let’s say you’re refinancing a 30-year mortgage you undertook two years ago, and you now qualify for a mortgage rate that’s a full percentage point lower than your current rate — you’re going from 5% to 4%. Although a refinance will mean it will take longer to pay off your loan, the trade-off is the money you’ll save. Based on the table above, your new mortgage rate would lower your monthly payment by $221.56 and cut down your interest payments by more than $70,000 over the life of the loan.

How much does it cost to refinance a mortgage?

The savings sound promising, but hold your enthusiasm. Don’t forget to answer this key question before moving forward: How much are the closing costs to refinance a mortgage?

A refinance comes with closing costs and fees that could range from 3-6% of the new loan amount. Charges usually include escrow and title fees, document preparation fees, title search and insurance, loan origination fees, flood certification and recording fees. On a nearly $291,000 mortgage, these expenses could add up to more than $8,000 or more.

In order to truly save money through refinancing, you’ll need to determine your break-even point, which is the amount of time it will take for your monthly payment savings to cover the costs you paid for the refinance. Using the numbers above, we would need to divide the estimated closing costs — let’s just use $8,000 in this example — by the $221.56 monthly payment savings. The math tells us it would take about 36 months — or three years — to break even. If you don’t plan on staying in your home for at least three years or longer, you should probably keep your existing mortgage.

Refinancing to lower your mortgage payments

If you’re thinking about refinancing to lower your monthly mortgage payments, you should understand that while you’ll pay slightly less every month, the amount you pay over the life of your loan will increase.

Refinancing simply to lower your monthly payment can be dangerous during the first five to seven years of paying off your current mortgage. That’s because interest charges are not spread out evenly over the course of your loan — they are front-loaded. That means for those first several years, you’re paying more toward interest than your principal loan balance. In the meantime, you’re building very little equity. If you refinance during this time frame, you’re starting the clock over and delaying the opportunity to establish equity.

Revisiting our previous example, let’s say instead of refinancing your 30-year, $300,000 mortgage after a couple of years, you waited until you were 10 years into the loan to refinance. Your goal is to lower your monthly mortgage payment, but in order to get the payment as low as you want, you extend your loan term by 10 years and start over with a new 30-year mortgage.

On your existing mortgage, nearly $600 of your monthly payment goes toward paying down your principal by year 10. If you were to start over, the amount you’d pay toward principal drops down to less than $400 for the first few years.

Refinancing to make home improvements

Some homeowners choose to pay for home improvements by refinancing a mortgage, especially if they don’t already have the cash on hand.

Cash-out refinance

One way to do that is through a cash-out refinance, which is when you borrow a new mortgage with larger balance than your existing mortgage. The difference between the two loans is given to you in cash. That available cash comes from the equity you’ve built from paying down your existing mortgage.

A cash-out refinance could work for you if you have built a significant amount of equity in your home. Most lenders limit the maximum loan-to-value ratio — the percentage of your home’s value that is financed through your mortgage — for cash-out refinances to 80%.

Choosing a cash-out refinance could make more financial sense than borrowing a personal loan or putting repairs on a credit card, since refinance interest rates are typically lower than those alternatives.

HELOC

Another option is to borrow a home equity line of credit (HELOC). This functions similarly to a credit card; you have a line of credit up to a set amount and only pay for what you borrow, plus interest. However, because a HELOC is secured by your home, interest rates are typically much lower than on credit cards. However, rates are generally variable and not fixed, which could cause problems later if you’re carrying a large balance on your HELOC and interest rates go up.

HELOCs usually have a draw period, when you’re allowed to borrow against the credit line, and a repayment period, when you can no longer borrow and are only repaying what you owe. During the draw period, the required minimum payments usually just cover the interest, but during the repayment period, you’ll have to make principal and interest payments that will likely be much higher than your interest-only payments — especially if your outstanding balance is high.

Either way, you should be cautious. Making an upgrade for the sake of functionality is one thing, but making an upgrade for the sake of luxury is another. If you’re thinking about tapping your equity to pay for a major project that may not boost your home’s value, it might not be wise to do so. If the luxury is something you really want, don’t finance it — save up for it.

Refinancing to consolidate debt

You might be tempted to use a cash-out refinance to pay off credit card balances or other high-interest debt. With mortgage interest rates hovering near historic lows, taking this route may seem like a good idea. After all, rolling your debt into a mortgage with a 4% interest rate is better than paying it off at 15% interest or higher, isn’t it?

Credit cards

There are some instances where rolling your credit card debt into a mortgage refinance can be advantageous. For example, if you’re in a dual-income household and you lose a spouse without adequate life insurance, you may find yourself in a financial bind.

In this scenario, if you have credit card debt in your own name and suddenly can’t afford to pay the monthly bills, refinancing your mortgage and cashing out a portion to pay off your debt may be one of the few feasible options.

Let’s say you owe $20,000 in credit card debt at a 15% interest rate. If you pay off that balance over the next five years, you’ll pay more than $8,500 in interest. However, if you add that same balance to a mortgage with a 4% interest rate, although you’re increasing your loan amount, you’ll likely pay less interest than if you kept the debt on your card.

Outside of scenarios similar to the one mentioned above, refinancing your mortgage to consolidate credit card debt often doesn’t get to the root cause of the issue. If you had a spending or cash flow problem prior to your mortgage refinance, you’re likely to end up in debt again. But this time, you’ll have a bigger mortgage to handle on top of the extra debt.

Instead of borrowing a bigger mortgage to get rid of your credit card debt, consider applying for a balance transfer credit card. Though these cards come with balance transfer fees, they can be as low as 3%, and you only have to pay them once. Many cards include an initial 0% interest offer on balance transfers for the first 15 months or longer. Because there is a deadline on the 0% interest period, you’ll likely find the motivation to pay the debt off quickly and build better financial habits along the way.

Student loans 

If you have student loan debt that could take decades to repay, refinancing your mortgage to access the cash you need to pay off that debt could potentially be a smart idea.

Fannie Mae, one of the two mortgage agencies that buy and sell mortgages from lenders that conform to their guidelines (the other agency is Freddie Mac), has a “student loan cash-out refinance” option that allows borrowers to refinance their mortgage and cash out a portion of the new mortgage to pay off student loans.

Let’s say you owed $30,000 on your home and had $20,000 in outstanding student loan debt. You would take out a new $50,000 mortgage, with $20,000 of it paying off your debt.

Going this route could make sense if the interest rate on the refinance is less than the interest rate on your student loans. Additionally, if you sell your home, the proceeds should take care of the portion of your mortgage that was dedicated to paying off your loans.

The drawback of refinancing to consolidate or pay off debt is that not only do you increase your mortgage balance — you lose your available equity. Be sure to weigh the pros and cons before tapping your equity.

The bottom line

A mortgage refinance can save you money, cut down on your interest payments or give you access to cash, but be sure you’re clear on why you’re refinancing and whether it makes sense.

If you’re refinancing to extend your loan term by several years and dramatically lower your mortgage payments, or remodel your kitchen to something of a chef’s dream, reconsider. But if you’re looking to snag a lower mortgage rate on a loan for which you’ve built significant equity, refinancing may be beneficial.

Before signing on any dotted lines, reach out to your loan officer, ask questions and run the numbers.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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How to Rebuild Equity on an Underwater Mortgage

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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There are some things you can’t control as a homeowner, such as natural disasters, neighbors or the direction of home values. If these happen to take a nosedive, you could watch the equity you’ve built in your home disappear.

In fact, more than 5 million homeowners are “seriously underwater” on their mortgages — meaning the amount of debt attached to their home is at least 25% higher than the home’s value, according to the latest data from ATTOM Data Solutions, a property research firm. If you’re one of these homeowners, don’t despair. There are ways to rebuild the equity on an underwater mortgage. In this guide, we’ll explain what it means to have a mortgage underwater and how to rebuild the equity you’ve lost.

What is an underwater mortgage?

An underwater mortgage is a loan with an outstanding balance that exceeds the value of the home it secures. This is also referred to as having negative equity or being upside down on your mortgage.
There are a few ways that a mortgage can become underwater:

  • Significant drop in home values
  • Multiple loans taken out against a home, and the total balance is higher than the home’s value
  • Monthly payments not covering the interest due on a mortgage (negative amortization), and the balance owed grows instead of shrinks

If you tried to sell your home while it’s underwater, the sales proceeds likely wouldn’t be enough to pay off your mortgage, which would leave you on the hook for the remaining balance. You’d also have a hard time refinancing your mortgage, since you need to have some equity available for a refinance in many cases.

How to tell when my mortgage is underwater

If your current mortgage balance is higher than your home’s current market value, then your mortgage is underwater.

For example, let’s say your home was worth $250,000 when you first bought it, and you took out a $200,000 mortgage with a 4% interest rate. Five years later, the economy takes an unfortunate tumble and home values drop by an average 40%, giving your home an approximate $150,000 value.

Based on your loan’s amortization schedule, the outstanding balance you’d owe in year five would be about $180,000. That leaves you with $30,000 in negative equity.

Negative Equity in Your Home

Estimated Home Value in Year 5

$150,000

Estimated Mortgage Balance in Year 5

$180,000

Available Equity

-$30,000

If you find yourself in a situation similar to the one described above, there are options available to help you rebuild your home equity, which we’ll discuss in the next section.

How do I rebuild equity?

Just because your mortgage is underwater doesn’t mean it has to stay that way. There are ways to start rebuilding the equity you might need to fund other financial goals.

Pay down your mortgage as usual

The most straightforward option is to continue to pay down your mortgage as you normally would. Perhaps the housing market will recover, leading to an eventual rise in home prices. Either way, as long as you’re submitting your mortgage payments in full and on time, you’ll pay it off on schedule.

You can help speed things along by paying extra toward your principal balance. There are several ways to tackle this, which might include adding a couple hundred dollars — or whatever amount is comfortable for you — to your mortgage payment each month.

Another option is to make biweekly payments instead of monthly payments. This can add up to one extra payment each year. That’s because there are 52 weeks in a year and you’d make 26 half payments, which equals 13 full payments.

Be sure to ask your mortgage lender or servicer to direct any extra money you pay on your loan toward your principal balance (not interest).

Modify your mortgage

If you’re experiencing a temporary hardship on top of your underwater mortgage and are struggling to keep up with your mortgage payments, you could benefit from a mortgage modification.

A modification is when your lender changes the original terms of your mortgage to make it more affordable for you. Changes might include:

  • Extending the number of years you have left to repay your mortgage
  • Lowering your mortgage interest rate
  • Reducing your outstanding principal balance
  • Switching your mortgage rate type from adjustable to fixed

Eligibility requirements vary, so it’s best to contact your lender for more information about how to modify your loan.

Recast your mortgage

Another way your lender can make tweaks to your existing mortgage is by recasting your mortgage — especially if you’ve recently come into a financial windfall.

A mortgage recast involves paying a lump sum of money toward your outstanding principal balance. Your lender then recalculates your monthly mortgage payments based on the lower principal balance, but your mortgage rate and term length stay the same.

You’ll need to pay at least $5,000 — sometimes more — to recast your mortgage, and you might also be charged a recasting fee, up to $500. Check with your lender for more details and requirements.
Conventional loans typically qualify for mortgage recasting, but not government-backed loans, such as those insured by the Federal Housing Administration (FHA loans) or Department of Veterans Affairs (VA loans).

Refinance your mortgage

Although the Home Affordable Refinance Program (HARP) — a government-sponsored initiative that helped nearly 3.5 million homeowners refinance their mortgages — has expired, there are other programs available that provide similar assistance.

Fannie Mae and Freddie Mac, the two major agencies that buy and sell mortgages to and from lenders that follow their guidelines, created new initiatives as HARP was ending to address those homeowners who were underwater on their conventional mortgages or have high loan-to-value (LTV) ratios. An LTV ratio is calculated by dividing your loan amount by your home’s value. Revisiting the underwater mortgage example above of a home worth $150,000 with a $180,000 mortgage balance, the LTV ratio is 120%.

Fannie Mae’s high LTV refinance option offers homeowners with an LTV ratio above 97% the opportunity to refinance their mortgage. Homeowners must be current on their mortgage payments and benefit from at least one of these options:

  • A reduction in the principal and interest portion of their monthly payment
  • A lower interest rate
  • A shorter loan term
  • A more stable mortgage, such as a switch from an adjustable-rate to a fixed-rate loan

There is no maximum LTV ratio for fixed-rate mortgages, but adjustable-rate mortgages (ARMs) have a 105% LTV maximum. The existing mortgage must be Fannie Mae-owned.

The Enhanced Relief Refinance mortgage offered by Freddie Mac also requires homeowners to be current on their mortgage payments and have an LTV ratio that is higher than allowed for a standard refinance. The maximum LTV ratio allowed for ARMs is 105%; there’s no maximum for fixed-rate loans.

Homeowners must benefit from a shorter loan term, lower principal and interest payment, lower mortgage rate and/or a move from an ARM to a fixed-rate mortgage.

If you have a government-insured mortgage — FHA, USDA or VA loan — you may be able to take advantage of a streamlined refinance, which typically has a limited credit documentation and underwriting process. Additionally, you may not need an appraisal to verify your home’s value.

  • FHA: FHA borrowers applying for a streamlined refinance must be current on their mortgage payments and benefit from at least a 5% reduction in their monthly payment amount. You may also qualify if you’re switching from an ARM to a fixed-rate mortgage or shortening your loan term.
  • USDA: Borrowers with USDA loans may qualify for the streamlined assist refinance option if they have little to no equity and are current on their payments. The benefit must come from a monthly mortgage payment that’s at least $50 lower than the existing amount.
  • VA IRRRL: The VA Interest Rate Reduction Refinance Loan program helps homeowners with VA loans by lowering their mortgage payment through a reduced interest rate. Guidelines require a minimum 0.5% rate reduction.

Other options for underwater homeowners

If you’re ready to walk away from your home or simply can’t afford it anymore, consider one of the avenues below:

Home sale

You could attempt to sell your home, with the understanding that you likely won’t make enough profit to pay off your mortgage. If you have a hefty savings account, you can use some of those funds to pay the difference between the amount your home sale covers and your outstanding loan balance.

Short sale

Another option is a short sale, which allows you to sell your home for a price that is less than the outstanding balance on your mortgage. Additionally, your mortgage lender may forgive your remaining mortgage debt. Keep in mind that your credit score will take a hit with this option — it could drop by 100 points, according to FICO.

Deed in lieu of foreclosure

A deed in lieu of foreclosure, also known as a mortgage release, is the process of voluntarily transferring the ownership of your home to your lender. In exchange, you may be released from your mortgage payments and debt. This option also prevents you from going into foreclosure.

Similar to short sales, a deed in lieu of foreclosure negatively impacts credit scores.

The bottom line

You may feel helpless if you’re dealing with an underwater mortgage, but you have options. If you’re able to manage your monthly payments as they are, it may be best to continue paying down your loan as usual, making extra payments whenever possible. But if you’re struggling or simply want to reduce your payment amount, consider a loan modification or a refinance.

Be sure to discuss your available options with your mortgage lender or servicer, and remember that maintaining on-time payments will help your case.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Crissinda Ponder
Crissinda Ponder |

Crissinda Ponder is a writer at MagnifyMoney. You can email Crissinda here

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