“Mortgage rates hit a record low… again!” A common headline in business news. But how do you take advantage of the amazing opportunity low rates bring if you have bad credit?
How Does Refinancing Work?
Refinancing a home simply means taking out new financing on a home you already own. There are several reasons real estate investors, and homeowners, would do this. Refinancing a home can help you lower payments, shorten loan terms, or get you some much-needed cash.
The question then becomes, how do you take full advantage of refinance options available? Because a refinance is a new loan, you would need to qualify based on today’s underwriting standards. Lenders look at things like the value of the house, income, and of course, credit. Because it is a brand new loan, you can change any term in the previous loan that was not beneficial. It could be as simple as a lower interest rate or longer term, or it could be something more complex like a restriction on renting the home.
Reasons To Refinance
There are many reasons someone would want to refinance but two stand out for real estate investors.
Save Money (Short-Term Vs. Long-Term, Improved Terms)
The great thing about a refinance is the tremendous amount of flexibility. You can use a refinance to extend a loan term which would lower your monthly payment. Combine this with a lower rate and you can magnify the benefit. A lower monthly payment creates more monthly cash flow with your tenants and will help you if you have a vacancy. The downside, of course, is it will take you longer to pay off the loan. With a refinance, you can also shorten the term, which could increase your monthly payment but save you thousands of dollars in interest. With each payment, you will have more applied to principal and less towards interest, so although your monthly cash flow will be less, your monthly profit will be much higher. This flexibility allows real estate investors to set up their rental portfolio to match the goals.
Secure Funds For Investment (Cash-out, Investment Properties)
One of the greatest advantages to investing in real estate is the ability to leverage it. You can buy a $100,000 house for a fraction of its cost because you can borrow against it. It is very common to control homes for as little as 20% of the actual cost. No other investment allows you to leverage to this level. Loans help you own more assets.
As you gain equity in your properties over time, you can access that equity without selling the house through a cash out refinance. A cash out refinance allows you to pay off the current debt and borrow more, putting cash in your pocket. This can be very effective if you are smart with the cash. Buying more rentals and increasing your monthly cash flow is a great way to invest cash from a cash out refinancing. One often overlooked but beautiful advantage to a cash out refinance is you will not pay any taxes on the cash. Because the cash is debt, it is not taxable. Be careful here because you will need to pay taxes on gains when you sell. If you are over leveraged, you might not receive enough proceeds to pay the taxes on the gains.
Qualifying For A Refinance Loan
Most refinance lenders have a standard to qualify. These are underwriting guidelines that you have to meet to get the loan. Think of it as a box: if you can fit into the box, you will get the loan but if you fall out of the box for any one item, you will be denied. When applying for a loan, the lender will look at the five C’s in credit approval:
Cash – They will look at how much cash you have in the bank as reserves. Every lender will have a reserve requirement which will vary typically from two months to six months of payments on all your mortgages.
Capacity – This is your debt to income ratio. Can you afford to make the payment based on your income and your other expenses?
Collateral – Lender will look at the property itself. This is normally done with an appraisal that will give background on things like, zoning, functionality, flood zones, negative influences, and of course value.
Conditions – This is typically looking at the loan itself. What are the terms you are asking for, the type of loan you want, and why are you applying for a loan?
Credit – Can the lender trust you to pay them back? Do you have a history of making loan payments on time or do you default on loans? Bad credit can be a tricky obstacle to overcome.
1. Improve Your Credit
Although it is true that lenders will have criteria around credit scores and your credit report, it may still be possible to get your refinance done. Here are some strategies to consider if you have less than perfect credit.
Check Credit Report For Inconsistencies
It is possible there are mistakes on your report. Government regulation requires that the credit bureaus offer you one free credit report a year. Normally, all three bureaus report the same data so if you see an error with Experian you can check the other two. That is not always the case though so it might make sense to get all three. The other two bureaus are Tans Union and Equifax. If you see something that you do not recognize or an error, you have the right to challenge the error. You do this directly through the credit agencies’ websites, but some experts claim it is best to do it through certified mail.
I don’t necessarily subscribe to this, but you can participate in credit repair or try credit repair yourself. The concept of this is that when you challenge something being reported, the creditor has the obligation to prove the reporting is accurate. For example, if there is a late payment on a mortgage being reported and you challenge it, the lender is forced to prove the payment was late or the late payment must be removed. If you are challenging items that are older, there is a chance the lender will not prove it or is unable to prove it, in which case the derogatory item must be removed.
Pay Down Your Debt
A large portion of your score is your debt to limit ratios. If you carry balances on your credit cards and unsecured lines of credit that are near or over the reported limit, this is killing your score. A quick way to boost your score is to increase your limits or pay down your debt. Obviously paying down debt is positive and shows that you are a good borrower so try that first. If you are unable to pay down debt, consider raising your limits. You do this by calling each of your credit card companies and asking them for a higher limit. Most of the time they can do this based on a solid payment history alone, but sometimes they will need to pull your credit report. Inquiries can impact your score, but the higher limit will normally help you more than the inquiry will hurt you.
One other strategy that can really help you here is moving personal debt to business debt. Business debt is not typically reported on your personal credit file and as long as it is legitimate business debt, you should be able to get it off your report. You do this by going through a business lender for secured and unsecured lines of credit or through a bank with business credit cards or other business loans. Be careful though, because if you mix business debt and personal debt you could be asking for trouble. I only bring this up because I know a lot of business owners that use their personal credit for business funding. Heck, I do that too. The rewards on personal credit cards are much better then business cards so I use a personal card for all my business purchases. This specific card, although in my personal name, is strictly business and there is no commingling. The downside of course is that it reports on my personal credit report.
Pay Bills On Time
This sounds so obvious but is so important. I have clients that cannot pay bills on time. Their reason, their bookkeeper forgets to pay them. My response? Get a new bookkeeper!
Your credit report is a direct reflection of you. If you cannot manage it, why would someone want to lend you money? Paying bills on time is essential for a great credit score. If you are currently behind on a bill, call the creditor and see if they would work out a payment arrangement where they will report the debt as current on payments. If not, consider transferring the debt to a new lender or a new credit card so that it will be reported as current on your report. It will take some time but paying your bills on time will improve your score.
Avoid Common Credit Mistakes
Here are the top four mistakes made when it comes to managing their credit scores:
- Maxing out your credit cards – As discussed, your usage to limit ratio is an extremely large portion of your score. Increase the limits if necessary, but do whatever you can to limit the balance of your accounts. Obviously, paying off the card each month is best but if you cannot do that, try to limit your usage to 30% or less of the limit.
- Closing old accounts – One factor in your overall score is average length of credit. If you have an open account that you have had a while, that pulls up your average and improves your score. Recently opened cards hurt your score. The only time I would ever recommend closing old accounts is if it is hurting you in some way, like an annual fee. And even then, do it after you have your refinance done.
- Applying with too many creditors – Inquiries can hurt you. It is a sign that you are looking for loans, and lenders look at that. Of course it is ok to have inquiries reported on your report, but if there are several in a short period of time, it can kill your scores. Many times mortgage lenders only look at scores, so a simple trick of getting inquiries removed or not having too many in first place will go a long way. It is good practice to be aware of who is pulling your report.
- Not using credit – As crazy as it sounds, the lack of credit is often worse than bad credit. You want credit and to show you know how to use it and a good mix of credit helps improve your scores. Mortgages, auto loans, and credit cards all help. I am not saying go into debt to improve your score but the idea of balance and usage is important. If nothing else, have a credit card just for gas that you payoff every month. You will never need to pay interest, you will help your credit score, and you might even earn some rewards.
2. Compare Lenders
It is very common that your loan, once originated, is sold to Fannie Mae or Freddie Mac. Those two buyers of notes are the largest in the country by far and are supported by the US government. Although extremely similar, both have their own set of guidelines that must be met before they would agree to purchase a loan. Lenders and brokers want to originate Fannie and Freddie approved loans so they can sell the loan, free up their cash, and make more loans. I think this is important to understand because as you are out shopping for loans, you will find that many lenders have the same guidelines. We call Fannie- and Freddie-eligible loans conventional. Conventional loans will be the best loans you can get. They have the lowest interest rates and most attractive repayment terms. My advice is to borrow conventional money if you can.
Obviously, your credit is a major factor with conventional lenders so if you don’t fit in their box, you have to look at other options. There are some lower-credit-score and creative mortgage products out there and the best way to find these is through a competent broker. Start with shopping for a good broker and let them shop for a good loan.
3. Apply For A Portfolio Refinance Loan
Portfolio lenders are those that keep their loans in their own portfolio. They do not sell to Fannie or Freddie, or anyone else. Although there are still some restrictions, portfolio lenders tend to have much more flexibility. I have seen some crazy approvals, like recent bankruptcies and no documented income. At the same time, they do still want to make good loans so you may find them extremely conservative in other areas. For example, they may want co-signers, larger down payments, or fantastic cash flowing properties.
Portfolio lenders are most commonly your local banks. Banks focusing on business lending will likely be your best option and the smaller the bank the better. They will likely want a relationship with you, as you should with them, so be prepared to move some accounts over if they agree to lend you money. The only way to find this loan is the old-fashioned way, you need to call them.
4. Use A Co-Signer With Good Credit
Oftentimes getting another signer on your loan will help your approval. That is not always the case with credit challenges, but it is absolutely worth asking. With conventional lenders, co-signers work great to help with income or reserve requirements but they will still deny loans if any borrower has certain credit hiccups being reported. This is not the case with alternative or portfolio lenders so don’t rule out this option.
5. Consider A Hard Money Loan
When I teach a class on hard money and it comes time to talk about credit I always say “A bankruptcy yesterday and you’re approved today” I have two points when I say this. First, credit is much less of an issue with hard money lenders than you will find with any other lenders. Also, recently bankrupt borrowers are safe borrowers. They have no debt, and they can’t file again as long as we have the loan.
I normally get a few chuckles from the attendees and the message gets through. Hard money lenders care about the overall deal, not any single item. If there is a challenge in one area, a good hard money lender will try to figure out how to overcome that.
I am not saying that a hard money lender will necessarily lend to someone with bad credit. There are times when the deal does not feel safe to them and they will say no, but if your credit challenges were in the past and you have corrected it and can explain it, you have a solid chance of being approved.
Hard money is most commonly used to purchase houses, not refinance them, but there are those times when it makes sense. If you find yourself in a situation where you think a hard money refinance will benefit you, give us a call. We would love to walk through your specific situation and give you some guidance.
Bad Credit Isn’t The End Of The Line
As you can see, just because someone has bad credit does not mean they are dead in the water. There could be options. Put in a little effort, try some different options, and call and ask for help. Also, as a real estate investor you should constantly be working on building credit and building relationships with lenders. Those are both vital for maximum success.