At the time that you took it, a subprime mortgage probably seemed like a good idea. It may have been your only choice. If you had poor credit or a high debt ratio, a subprime loan was probably the only way you could buy a home. Fast forward a few years and you may be tired of paying that higher interest rate. But when is the right time to refinance?
You need to figure out where you stand to determine the right time to refinance.
Evaluate your Situation
Stop and think about the reasons that you took a subprime mortgage. Did you have a low credit score? Was your debt ratio too high? Did you have a recent negative credit event, such as a foreclosure or short sale?
The reasons that you needed the subprime mortgage should be behind you. Stop and look at your situation now and compare it to then. If you had a low credit score, what’s your credit score today? Has it improved much or is it still close to what it was back then? What about your debt ratio, is it low enough for standard mortgage standards or will conventional lenders still be wary of giving you a mortgage?
Knowing where you stand now will help point you in the right direction. If things look much different today than they did when you took the subprime mortgage, now may be the right time to refinance. If not, you may have some work to do. Keep reading to see how you can improve your situation to get the best deal on a new mortgage.
Improve Your Credit Score
Ideally, you want a minimum credit score of 680. That’s the minimum credit score conventional lenders allow. If you don’t have at least a 680, you may still be a good candidate for a government-backed loan, such as an FHA loan, but you may want to wait.
Looking at your credit history, ask yourself:
- Are you making your payments on time (no 30 day late payments)?
- Are you keeping your outstanding debt at less than 30% of your available balances?
- Do you have a decent mixture of installment debt and revolving debt?
- Have you avoided opening new credit lines in the last 12 months?
These habits will help your credit score increase. If you made late payments in the last few minutes, take some time to get caught up. Your credit score will take time to reflect the better habits, so give it time. The same is true for your utilization ratio. Keep your outstanding balances low compared to your available credit line in order to maximize your credit score. Once you get that 680 credit score or higher, you’ll have a better chance of securing conventional financing.
Lower Your Debt Ratio
Lenders like to see that you have few debts aside from the mortgage. This increases the likelihood that you’ll make your mortgage payments on time. If you have a lot of revolving debt, consider paying the balances down to help your debt ratio.
Conventional mortgages allow the following debt ratios in most cases:
- 28% housing ratio – This is your principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance compared to your gross monthly income
- 36% total debt ratio – This is a combination of all of your debts including the new mortgage compared to your gross monthly income
The closer you are to the above debt ratios, the better your chances of securing a conventional loan. A low debt ratio can even be a compensating factor that convinces a lender to give you a conventional loan, even if you don’t have a 680 credit score, in some cases.
Get to an 80% LTV
Finally, you should wait until you owe less than 80% of your home’s value before refinancing your subprime loan. Here’s why. If you refinance when you owe more than 80% of the homes’ value, you’ll pay private mortgage insurance. This is in addition to the principal and interest that you pay on a loan. It may not be worth refinancing if you have to pay the PMI.
If you wait until you pay your mortgage balance down to 80% of today’s value (the home may have appreciated), you avoid the PMI and save the most on your refinance. Refinancing while you have to pay PMI may not save you as much money on your monthly payment since the PMI increases the amount that you owe each month.
Figure Out Your Break-Even Point
The easiest way to tell if it’s time to refinance is to calculate your break-even point. This is the point that you make up for the closing costs the refinance will cost you. Use the following calculation to figure out your break-even point:
Total closing costs/Monthly savings = Months to break-even
You can then look at the months to break even and decide if it’s worth it. For example, if it would take you 10 years to break even, it probably doesn’t make sense to refinance right now. You may want to wait until your qualifying factors allow you to get a lower interest rate or lower closing costs.
If it would only take say 2 years to break even, though, that may be well worth it for you. Think about how long you plan to stay in the home and gauge it that way. If you know you’ll stay in the home for 10 more years, 8 years of savings can amount to quite a bit.
Knowing when to refinance your subprime mortgage depends on many factors. Look at the big picture to see when it makes the most sense for you. Then you can make the decision that benefits your financial situation the most.