How to Refinance Now and Avoid Rejection

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Last Updated Dec 7, 2009 11:10 AM EST

For Anne Marie and Jeff Swinehart, it seemed like the perfect time to refinance their Lancaster, Pa., home. Mortgage rates had slipped to 4.75 percent — far below their 5.85 percent loan. And with low debt and a fastidious devotion to paying bills on time, they assumed their credit scores were exemplary.

But when the bank pulled their credit report, Jeff, an executive at a local land conservation group, was shocked to see his FICO score had tumbled into the 600s. The couple had failed to pay a $25 utility bill on a previous home because they never received it. Even though the lost bill was due to the company’s error, it shredded Jeff’s credit score, and the Swineharts’ refinancing plans fell apart.

“We were told we’d have to pay points to compensate for the ‘low’ score,” says Anne Marie, a public relations specialist. “The credit agency said it could take up to six months to eliminate the mark. It’s almost six months later and my husband’s credit score is still tarnished.” Refinancing? Still hasn’t happened.

You could fall victim to similar refi killers if you don’t prepare carefully before applying for a new loan. In a housing market weighed down by foreclosures and plummeting values, lenders are routinely rejecting refinancings or making them unaffordable. Rampant layoffs have only added to banks’ fears. “Lenders have become much more gun-shy about approving loans,” says Steve Hines, president of the mortgage division at Aliant Bank in Birmingham, Ala. “The underwriting environment has become a lot more skeptical and critical.”

These are the five most common reasons refi lenders are turning down applicants, and how to counter them:

1. Credit Report Snafus

As the Swineharts learned, even a single missed or late bill can torpedo otherwise stellar credit. And you’ll soon need to be more vigilant about your credit score, since lenders’ credit standards are about to become even more stringent. Starting in January, anyone refinancing through Fannie Mae, the quasi-government corporation that, along with Freddie Mac, owns or guarantees roughly half of all mortgages, must have a credit score of at least 620, up from today’s 580.

You may also be lulled into thinking your credit score is higher than your lender does. That’s because lenders pull reports from all three credit reporting agencies — Experian, Equifax and TransUnion — and then use the middle score to determine whether you’ll qualify and what rate and fees you’ll pay. If you get your score from just one agency, you might not be seeing the score you’ll be judged on.

  • What to do: Check your credit scores several months before applying. That way, you’ll avoid any unpleasant credit surprises. You can get reports from all three agencies free of charge at annualcreditreport.com. Look for mistakes, outdated information and other inaccurate data. Notify the agencies in writing of any errors and follow up to make sure the mistakes are corrected. If your credit score is under 700, fix it before trying to refinance or don’t bother applying for the loan.

2. Too Much Debt

Credit cards, car payments and other loans are a land mine lying in wait for would-be refinancers. Lenders look at two ratios that compare your income with your expenses: the housing ratio and the debt ratio.

The housing ratio divides your monthly mortgage costs by monthly income. While lenders accepted a housing ratio upwards of 35 percent a couple of years ago, most now want to see that your refinanced mortgage costs won’t total more than 29 percent of your income, says Randy Mitchelson, an Estero, Fla., mortgage broker.

The debt ratio is what you get by adding up all your monthly debt payments, including the mortgage, and dividing them by your monthly income. Says Mitchelson: “Today, most lenders require that no more than 36 percent of your income goes toward paying debts.” To illustrate: if your monthly income is $10,000 and your monthly debt payments total $3,000, that’s a 30 percent ratio.

  • What to do: Lower, or reallocate, your debt. As with your credit report score, be sure you know your housing and debt ratios before applying to refinance. Calculators at bankrate.com can help you do the math. If your debt is a potential deal buster, bring down what you owe to a more acceptable level. Go easy on the credit cards; pay off a car loan if possible. Ideally, take these steps several months before refinancing, to give the credit agencies enough time to update their records.

    Also, don’t let a lender snub you for improper “credit utilization.” That’s the term for how your debts are distributed. If you have three credit cards with $10,000 limits and carry $9,000 in debt on one card but next to nothing on the others, that’s a potential red flag. Instead, says Michael Moskowitz, president of Equity Now, a New York-based mortgage lender, spread your $9,000 in charges more equitably among the three cards. That will keep you from hitting a card’s debt limit, which is another red flag.

3. Falling Home Values

In areas hit hard by foreclosures and plummeting values, lenders now automatically lop off 10 percent from appraisals before deciding whether to approve refi applicants, says Mitchelson. And if your house has been appraised for less than its purchase price, you’re almost certain to be rejected.

  • What to do: For starters, if values have dropped substantially where you live, you may want to hold off on a refi. Otherwise, you may wind up spending hundreds of dollars on an appraisal, only to see your application rejected. If you do apply for refinancing and you’re turned down due to a low appraisal, you can’t shop around for a seller-friendly appraiser. Lenders must now, by law, use appraisers from preapproved lists. So the best you can do is to review public home-sale records from sites such as Zillow.com to see if there are recent sales of comparable homes that suggest a higher appraisal. Then ask your lender to have the appraiser take a second look and, ideally, produce a revised, higher appraisal.

4. Leaving a Job

With unemployment around 10 percent, lenders are becoming more concerned about applicants who can’t show a solid employment history. Says Mitchelson: “If you’re looking for work, you have little chance of getting a loan since you have no income to repay it.”

  • What to do: Refinance now if you expect to leave a job soon (voluntarily or otherwise). Lenders generally want to see at least two consecutive years at one job. And prepare for a difficult time getting approved if you’ve just started your own business. Lenders are likely to be dubious about your ability to bring in steady income to make the mortgage payments.

5. Trying to Sell First

In the current climate, many homeowners hope to lower their housing costs by trading down, but find that they can’t attract buyers. So after unsuccessfully trying to sell, they apply to refinance, figuring they’ll list their house again when the market improves. But recently listed homes can be difficult to refinance. Lenders sometimes check the multiple listing service to see if a refi applicant’s home has been on the market. If it has, they’ll often refuse to proceed with the application because a quick sale of the house will prevent them from receiving some anticipated fees from the homeowner.

  • What to do: Hines recommends keeping your home off the market for at least six months before filing to refinance.

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