For lower-credit homeowners, refinancing is harder, but not hopeless

With mortgage interest rates hitting record lows, many homeowners have already refinanced — but others are having trouble finding a lender that will approve a new loan.

According to a report from the Urban Institute, between January and June 2020, it became substantially more difficult for homeowners with FICO scores of less than 700 to be approved for a refinance.

In July 2020, 9.49% of refinances went to borrowers with credit scores between 500 and 699, according to Ellie Mae data, compared with 20.13% in July 2019. It’s part of the continued fallout from COVID-19, which has had major impacts on the housing market.

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Since the spring, lenders have raised minimum credit scores so much that a FICO score of 700, within the “good” range of 690-719, may be deemed too low — even for borrowers who’ve been able to maintain their employment and have consistently paid their mortgage.

That includes loans backed by the Federal Housing Administration, which are designed to help homeowners facing credit challenges.

With FHA-approved lenders tightening their lending criteria, these loans have become increasingly difficult to get. This leaves many homeowners whose tight budgets could potentially benefit the most from refinancing unable to take advantage of low interest rates.

Even so, it may still be possible to refinance if your credit score isn’t in the top tier.

Here’s what’s happening, and some of the tactics you can use to find the right lender and get approved.

Why COVID makes mortgage lenders anxious

Millions of homeowners have gone into forbearance during the pandemic, putting off their monthly mortgage payments. Analysis by the Urban Institute notes that the wide availability of forbearance has likely “kept the most vulnerable homeowners from losing their homes.”

At the same time, explains Laurie Goodman, co-director of the institute’s Housing Finance Policy Center, lenders are tightening their purse strings in order to avoid taking on new loans that might enter forbearance.

Forbearance is costly to loan servicers.

They face financial penalties from the government-sponsored enterprises that buy loans (Freddie Mac and Fannie Mae), as well as government agencies like the FHA.

Between forbearance penalties and broader fears about effects of the recession, lenders have grown increasingly picky about borrowers. That’s made it hard for homeowners with lower credit scores to refinance and take advantage of lower rates.

FHA borrowers have to clear a higher bar

The FHA is part of the U.S. Department of Housing and Urban Development, or HUD. FHA loans are intended to help people who wouldn’t qualify for conventional loans; for purchase loans, the minimum credit score is 580 with a down payment of 3.5%, and several types of refinancing options are offered as well.

But finding an FHA-approved lender that will consider a credit score that low has become virtually impossible. Since lenders are allowed to make their own guidelines, many would-be FHA refinancers are finding themselves shut out.

“HUD and FHA have not changed their guidelines; there was no announcement on any type of changes, but many investors have decided to move away from those types of borrowers,” says Miguel Narvaez, chief production officer at Las Vegas-based Alterra Home Loans.

Narvaez notes that he’s seen lenders who have not upped credit score minimums instead raise the pricing on loans to low-credit borrowers. In order to get a better rate, borrowers have to put down more money upfront, usually in the form of buying discount points.

These higher bars to access, which often aren’t encountered until a borrower tries to apply, are called overlays. Goodman likens these to mats placed in a picture frame: Think of the basic FHA requirements as the area of the frame, and the overlays as a series of mats, making the part of the picture that’s visible smaller and smaller.

In the same way, the number of borrowers who are able to qualify for an FHA refinance grows smaller with each overlay.

How to improve your refinancing chances

Shop around. You should always look into at least three lenders to compare rates, but in this environment, credit-challenged borrowers may need to shop more widely. Be sure to look at all the costs, especially if a lender is encouraging you to buy points to reduce your rate. Points are essentially interest that is prepaid at the beginning of the loan. They’ll lower your rate, but add to your closing costs.

Consider all types of lenders. Goodman notes that nonbank mortgage lenders have remained more open to borrowers with lower credit scores or other financial challenges than traditional banks. Smaller local lenders, such as credit unions, may also be worth checking out — establishing a face-to-face (these days, mask-to-mask) relationship can help. You could also seek out lenders that are willing to consider alternative credit data, such as on-time cell phone or utility payments.

Correct any credit report errors to strengthen your score. Call it one tiny benefit of the coronavirus: Through April 2021, you can request your official credit reports from TransUnion, Equifax and Experian as often as weekly for free at AnnualCreditReport.com. Review your reports, and file a dispute if you find an error.

Look into a streamline refinance. If you’ve got an FHA loan, Goodman points out that with some FHA streamline refinances, you don’t need a credit check. You can’t take cash out and you won’t eliminate the FHA mortgage insurance premiums, but a non-credit-qualifying FHA streamline refinance can potentially help you refi to a lower interest rate with fewer hurdles.

Wait it out. As the future becomes more certain and the economy recovers, lenders are likely to ease credit restrictions. Narvaez notes that his company has already lowered credit score minimums after raising them in the spring, and he anticipates a return to pre-COVID levels “as the economy is more stable.” If by then you’ve got a higher credit score, you’ll be more likely to qualify for a better rate than you would now.