Overcoming Three Refinancing Roadblocks
The real estate market is tougher than it used to be in some areas. Because lenders have significantly tightened their standards, refinancing may be difficult these days — especially if you have little equity, low income, poor credit or large amounts of debt.
Fortunately, if you’re stretched financially thin right now and want to refinance your mortgage to a better rate, there are some options available to you.
Here are the three most common refinancing obstacles as well as the most effective ways to overcome them.
Obstacle #1: Lack of Equity
Inadequate or negative equity is probably the most common refinancing problem in the book. When lenders decide whether or not to offer you a loan, they factor your equity into their loan-to-value (LTV) ratio. Many lenders require an LTV of at least 80 percent before they’ll approve you for a loan.
You will probably be assigned a low LTV ratio if:
- You bought your home with no down payment.
- You took an interest-only or payment-option mortgage.
- You refinanced your original mortgage to get cash.
- Your home value has plummeted.
How to Overcome This Obstacle: Reduce Your Principal
If you have a low LTV ratio, you may want to lower your loan amount. This may hike up your LTV enough so you’ll be approved for a loan. To lower your loan amount, you can pay a lump-sum payment or a gradual reduction of principal — or both. If you have extra funds to apply, say, $300 to $500 a month toward your principal each month, you will greatly lower principal and the interest that’s being charged on your outstanding principal.
You may consider withdrawing money from a savings or retirement account, selling another asset or using an income tax refund or job bonus. Of course, by tapping into these assets, you are losing any income that may have been earned from these investments. It’s extremely important to evaluate your overall financial situation before making such a major move. Discuss your options with your financial advisor who can help you determine what makes the most sense for your unique situation.
Obstacle #2: Low Income/ High Debt
If you earn little income and/or carry a significant amount of debt, you may have what’s considered a high debt-to-income (DTI) ratio. Lenders factor in both your income and debt to calculate your DTI ratio, and the resulting number plays a major role in determining whether or not you’ll be approved for a loan. After all, lenders want to make sure that you have enough income to make your mortgage payments on time each month.
If you’re self-employed, have recently lost your job, overstated your income on your original loan application or carry excessive amounts of debt, you probably have a high DTI ratio. The higher your DTI ratio, the higher the risk you are to a lender-and the less likely you’ll be approved for a refinance loan.
Lenders typically want your DTI to be no more than 38 percent. That means your debt should equal no more than 38 percent of your income. However, this is just a general rule of thumb because DTI ratio standards vary from lender to lender.
How to Overcome This Obstacle: Raise Income, Lower Debt
The solution to a high DTI is obvious: earn more income and pay off your debt. Of course, this is much easier said than done. However, if you want to refinance your home badly enough, you can make it happen.
You can earn more income by asking for a salary increase, switching to a higher-paying job or taking on a second job. However, your second job must be considered a “stable permanent position” for it to count toward your DTI ratio. Most lenders require that you work in a position for two years before they consider it a “permanent” job.
Additionally, if you can qualify for an FHA-insured loan, you may be able to add a non-occupant co-signer (such as a parent) to your loan application. Your co-signer’s income will be added to the equation-but remember, their debts will count toward your overall DTI ratio, as well.
You may also consider documenting other sources of income, such as annual bonuses, limited partnership payouts and any rent money you may earn. Although documenting and explaining these other sources of income may be a challenge, it could be well worth the extra effort. After all, these other sources of income could greatly benefit your DTI ratio.
If your DTI ratio is high because you have excessive debt, you should focus on paying off those debts. Some financial experts say if you’re looking to refinance, it may even be worth spending your savings to pay off debts. For example, if you owe $4,000 on a car loan, and you have $5,000 of extra funds in the bank, consider using that money to pay off the car loan. This could greatly reduce your DTI ratio. Of course, if you are carrying any high-interest credit card debt, you should pay that down first.
Obstacle #3: Poor Credit History
Your credit score is calculated based on your credit history, including whether or not you pay your bills on time, how much debt you’re carrying and how well you handle your financial obligations. If your credit score is low, lenders will see you as a high risk.
In the past, many lenders overlooked a low credit score, but things have changed. If you have a low credit score, you may be able to refinance, although the interest rate may not be low enough for it to be worth your while.
How to Overcome this Obstacle: Improve Your Credit
The most effective way to hike up a low credit score is simply to pay your bills in full and on time. Of course, it will take at least six months before this good financial behavior will show up in your credit score. If you find errors in your credit report that are negatively affecting your score, call the credit bureaus and challenge this information.
About Michael Smeriglio:
Michael Smeriglio is a financial specialist. A licensed CPA since 1985, Mike has been providing tax preparation services to individuals and businesses for more than 30 years through his firm located in Greenwich, CT.