With interest rates low, homeowners looking to refinance their mortgages are finding out the hard way about tough new lending restrictions. If you’re saddled with too much debt these days, chances are, you’re going to be out of luck if you’re looking to lock in a lower rate.
Everybody knows that there's a shortage of credit in the economy right now. Major lenders such as Bank of America (Stock Quote: BAC) and Citibank (Stock Quote: C) have tightened their lending restrictions, and even government-backed mortgage giants Freddie Mac (Stock Quote: FRE) and Fannie Mae (Stock Quote: FNM) are getting more cautious to reduce the impacts of rising loan defaults. While that might improve the industry's bottom line, it's catching a lot of would-be borrowers by surprise.
Credit scores are a big determinant of whether a lender deems you worthy for a loan. And your credit score will suffer if you've used up more than a third of your available credit, or “credit utilization” in industry-speak. It's a little known component of your credit score that's affecting many consumers these days.
"There's definitely an increasing number of credit scores that have fallen based on higher debt levels," says Carol Wilson, a financial education specialist with Consumer Credit Counseling Services of Atlanta. "And lenders don't want to extend credit unless a score is 680 or above, which means it's very important for consumers to lower their debt levels."
With lenders lowering credit limits on credit cards and other loans, borrowers are suddenly finding out that their existing debt is taking up a bigger percentage of what’s available to them.
Wilson recommends making it a priority to lower your credit balances. That could mean using cash from savings to pay down the debt, or it could mean sacrificing some of your down payment. "Using too much credit can have a huge negative impact on your score," explains Wilson. "If you have money for a down payment, you're likely better off shifting some of it towards paying down your debt."
Another way too much debt can hurt your chances of refinancing is through your debt-to-income ratio. This ratio compares your monthly debt payments on such things as credit cards, student loans and your mortgage, with your monthly gross income. According to Wilson, you might not qualify for a conventional loan if your ratio exceeds 38% -- the threshold is 43% on Federal Housing Authority (FHA) loans.
Most lenders will recommend that you lower your debt if your credit utilization and debt-to-income ratio are too high, even after the application process has begun. While that might give you a second chance at qualifying for the best rates, it could take time and delay your refinancing. Best bet: Find out ahead of time whether you have too much debt.
To calculate your credit utilization, order a free copy of your credit report from AnnualCreditReport.com and divide your current balances by the total of your available credit. For your debt-to-income ratio, divide your fixed monthly debt payments -- such as your rent or mortgage payments and your credit card minimum payments -- by your gross monthly income, which is your monthly salary plus one-twelfth of your annual bonus, investment gains or other irregular income. Multiply the resulting number by 100 to get your ratio.
As lenders get more and more selective about the risks they take, the best candidates are the borrowers with the least amount of debt. Do yourself a favor and start cutting the debt out of your financial diet now if you’re hoping to refinance your mortgage.