Refinancing is the process of replacing an existing loan with a new loan that pays off that loan. Doing so may allow you to save money on interest, lower your monthly payment, or switch from a variable interest rate to a fixed rate.
Whether you plan to replace a home, auto, or student loan, you'll generally need to go through the loan approval process again. Understanding what qualifications you need to refinance a home will allow you to look over your finances in the same way a lender would before you submit an application. This way, you can identify potential gaps in the refinancing requirements and take steps to improve the odds of loan approval.
Qualifications for Refinancing
While requirements vary by lender and loan type, in general, you'll need the following to secure a new (and better) loan:
- Decent credit
- Sufficient income
- Sufficient equity
You don't need perfect credit to qualify to refinance a loan. Some government programs require a credit score of only 580, while other loans impose no minimums. To qualify for a standard mortgage refinancing, however, you generally need a credit score of at least 620.
The better your credit history, the higher the odds of loan approval at lower interest rates and more favorable terms. The key is to make your credit look as good as you realistically can. Here's how you can do that:
- Know your credit. Under the Fair Credit Reporting Act (FCRA), you can obtain one free credit report per year from each of the three credit bureaus. The easiest way to get these reports is through the FCRA-mandated website AnnualCreditReport.com. You'll need to answer questions to prove your identity and then pick reports to view. If you prefer, call 877-322-8228 to request a copy of your credit reports by phone.
- Fix errors. Review each entry in your reports and verify that it’s accurate. In particular, look for negative items such as late payments and collections. If those shouldn’t be on your report, contact the relevant credit bureau online or by phone or mail to get them removed. If the information is accurate, you might not easily be able to remove it, but it’s worth a try.
- Pay down balances. Your credit score can fall when you max out your credit cards because doing so increases your credit utilization ratio (the percentage of total available credit that is in use) to 100%. That's more than three times the recommended ratio of under 30% (and the lower you can keep it, the better). If you have free cash available that you won’t need after you borrow, consider paying down your loan balances. Staying well below your credit limits may help you qualify to refinance a loan.
Another way to reduce your credit utilization ratio is to request a credit limit increase so that your balance makes up a smaller percentage of your total available credit. But keep in mind that doing so can require a hard pull on your credit report and a small, temporary dip in your credit score. That could affect the interest rate you get on the new loan.
Since your income may be different than it was when you got your current loan, you'll also need to prove to lenders that you can repay your new loan.
- Determine how much you need. Start by understanding what the monthly payments will look like. A basic loan calculator can tell you what to expect for these payments.
- Evaluate whether your income covers it. Next, verify that your debt-to-income ratio is reasonable. This metric describes how much debt you carry as a percentage of your monthly income. Lenders use it to verify that your monthly payment won’t eat up too much of your current income. Most prefer a ratio of no more than 36%, though some will accept a ratio of up to 50%.
Get familiar with your loan-to-value ratio (LTV), which measures the amount you owe on your loan in relation to the market value of the home, car, or other asset securing the loan.
Lenders use the LTV ratio to assess your risk; the higher the ratio, the more the lender would lose if you were to default on your loan, and the riskier you appear as a borrower. Since equity represents how much of your home you owe after debt, the more equity you build in your home, the less you owe as a percentage of the asset value and the lower your LTV ratio. The acceptable LTV ratio depends on the type of loan you're taking out:
- Home loans: In most cases, you can qualify to refinance your mortgage with at least 20% equity and an LTV ratio of up to 80%. While it may be possible to refinance with a higher LTV ratio, you may have to pay private mortgage insurance (PMI) expenses if you do so, which can reduce the value of the refinancing.
- Auto loans: You can refinance a vehicle at any time, and lenders may allow you to go up to 100% LTV. The limit depends on your vehicle (new, used, motorcycle, or RV, for example).
Getting a Loan Without the Qualifications
If you find that you don't meet your lender's refinancing requirements because of your credit, income, or LTV ratio, there are still ways to qualify for a better loan.
Get a Cosigner
If you have poor credit or insufficient income, consider asking a cosigner to sign for the loan with you. A cosigner is a person who agrees to make payments on the loan in the event that you can't, and they can increase your odds of approval since they make lenders more confident about getting repaid. If the cosigner has strong credit, approval is even more likely.
But a cosigner takes on risk, since they may have to take on your debt. If neither of you can repay the loan, you will both take a hit to your credit.
Participate in a Loan Program
If you can’t refinance because you have insufficient equity or your home is underwater (you have negative equity), investigate government loan programs. Refinancing programs from organizations including the Federal Housing Administration, U.S. Department of Agriculture, and U.S. Department of Veterans Affairs help homeowners who have fallen on hard times. You can only refinance through these programs if you meet certain criteria, but it’s worth a try.
If you qualify, government loan programs are often your best bet if you can’t refinance with a bank or mortgage broker. Those programs have the most lenient terms when it comes to qualifying credit scores and equity. Some even let you borrow to buy a home one to three years after bankruptcy.
Moving Forward With a Refinance
Ultimately, the only way to find out whether you meet the qualifications to refinance a loan is to initiate the process of getting a new loan.
Once you've fixed issues relating to credit, income, and equity that are under your control, shop for lenders and then contact one to start a conversation about refinancing requirements.
Discuss your existing loan and what you hope to get out of a new loan. If you're satisfied with what's on offer, apply for a loan.
If approved, carefully review the loan terms and fees before you sign an agreement with your lender. With more favorable loan terms, you should be able to make payments comfortably going forward.