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What is a short refinance, and how does it work?

Yahoo Personal Finance· Getty Images
Laura Gariepy
5 min read

As a homeowner, you may face periods of money insecurity that make it difficult to afford your mortgage payments. Fortunately, you can explore several strategies to help you keep your house or minimize the financial damage.

One of the lesser-known methods is the short refinance. We’ll explain what a short refinance is, how it works, and when you might want to pursue one. We’ll also offer several alternatives for you to consider. That way, you can get through your economic struggles in the best possible position.

In this article:

Learn more: Mortgage refinance — how to get started

A short refinance involves replacing your current mortgage with a new loan for less than what you owe. It’s an option if you are at risk of foreclosure. Your lender will ultimately receive less money for the property, and your monthly payments will be lower. You’ll get to stay in the residence as long as you make timely payments on your new home loan.

Your mortgage lender may agree to the arrangement if you’ve defaulted on your mortgage or will likely do so soon. While a short refinance results in a loss for your lender, it may still be a wiser financial move for both parties than foreclosing on your home.

With a short refinance, your lender will still get a steady (albeit reduced) income stream from your monthly mortgage payments. If your lender forecloses on your home, it could take a long time to sell it and generate revenue.

You must demonstrate financial hardship to qualify for a short refinance. To be eligible, your lender might require you to be underwater on your mortgage, also known as having negative equity. You’re underwater on your mortgage if the remaining balance exceeds the appraised value of your property.

Read more: 5 steps to prepare for a mortgage refinance

During the Obama administration, short refinances saw a surge in popularity. The then-president launched a program allowing underwater borrowers to refinance their non-FHA mortgages into FHA mortgages, insured by the Federal Housing Administration, with a lower balance. The program, which ran through 2016, helped consumers stay in their homes.

However, short refinances outside that program are relatively rare because many lenders won’t process them due to the guaranteed financial loss. Current economic conditions also mean the financial product doesn’t make much sense for many borrowers.

In general, home values have soared in recent years, giving homeowners more equity and more options. It’s less likely for a homeowner to be underwater on their mortgage loan now than during the Obama presidency. Home prices aren’t expected to drop steeply anytime soon, either, due to an ongoing housing shortage.

In addition, interest rates have risen alongside property values. Many homeowners don’t see refinancing their mortgage as a net financial gain because the savings generated from a short refinance may be negated by the additional cost of taking out the new home loan.

Learn more: When will mortgage rates go down? A look at 2024 and 2025.

While there’s a lot of upside to short refinancing for you as the borrower (namely, the ability to stay in the home with a reduced monthly mortgage payment), there are also some pitfalls to consider. Your credit score will likely drop because a short refinance will show up on your credit report as a settlement rather than a repayment and because you repaid a debt (your original mortgage) for less than agreed. As a result, it may be difficult to obtain another mortgage for a set period, Phil Crescenzo, division manager of Nation One Mortgage, said via email.

In addition, the home loan balance you no longer have to pay is considered forgiven debt and, therefore, taxable income. You may need to work out a payment plan with the Internal Revenue Service to pay off what you now owe.

Learn more: Do you have home buyer's remorse? Here's what to do next.

If short refinancing isn’t the right fit for your circumstances, you have other options. Consider the following:

  • Traditional rate-and-term refinance. If you haven’t defaulted on your mortgage and you have positive home equity, this is a good home refinance option. You may be able to refinance the debt to secure a lower interest rate or a longer loan term, which will reduce your monthly payments.

  • Forbearance agreement. Your mortgage lender may be willing to postpone your mortgage payments for a set period, giving you time to regroup financially. The missed loan payments will usually get tacked on to the end of your loan term.

  • Loan modification. Your lender may be willing to extend your existing loan term to lower your monthly payment. However, you will pay more in interest over the life of the loan.

  • Short sale. Your lender might permit you to sell your house for less than you owe to avoid a long, expensive foreclosure process. If you go this route, you’ll need to leave your home, and your credit score will likely suffer.

  • Deed in lieu of foreclosure. Here, you agree to surrender your home’s deed to your lender in exchange for having your existing mortgage debt wiped clean. While you will lose your house in this scenario, your credit score may not suffer as much damage as it would if you went through an official foreclosure process.

If you short refinance a mortgage, your lender refinances the property for less than you owe, reducing your debt burden. That means you can stay in your home while making a smaller monthly payment. However, your credit score could drop, and you may need to pay taxes on the forgiven debt.

A lender may want to offer a short refinance to a borrower if it could get more money than by selling the home after foreclosure. A short refinance results in continued revenue for the lender (unless the homeowner defaults). On the other hand, a foreclosure sale could take a long time to finalize, leaving the lender without revenue until the house sells.

An FHA short refinance was an Obama-era financial intervention designed to help underwater borrowers keep their homes. Through 2016, borrowers could short refinance their non-FHA home loans into FHA mortgages with reduced principal mortgage balances.

This article was edited by Laura Grace Tarpley