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17 May 2004
"I have been approached by a
lender to refinance at a higher rate in order to pay off debts and improve my
credit score, which the lender says is 525. He says that in a few months when my
credit rating is higher, I can refinance again to lower the rate. This all
sounds good, what do you think?"
Going ahead with this deal would
violate two of my most important rules for avoiding victimization. 1. Don�t
respond to solicitations. 2. Don�t refinance at a higher rate. There are
exceptions to both rules but this deal is not one of them. Let�s look at the
two parts of the proposal separately.
Debt Consolidation: The
lender would consolidate your short-term debt into your mortgage. Assuming the
interest rates on this debt are high, making them a part of the mortgage would
reduce their cost. It is not clear that your overall debt cost would decline,
however, because the new mortgage rate would be higher than the old rate. The
cost of your short-term debt would decline but the cost of your mortgage would
rise.
Whether your overall cost would rise
or decline depends on all the rates and balances, as well as on your tax rate
and other factors. The debt consolidation calculators on my web site are
designed to convert this information into conclusions about overall cost.
But even if the overall debt cost
would decline, consolidation might not be in your best interest. It turns
unsecured debt into debt secured by your home. If your credit score is really
525 (out of a possible 850), you have had problems in the past in meeting your
obligations. Increasing your mortgage debt increases the probability that your
next problem will put your home in jeopardy. The other risk from consolidation
is that it will encourage you to start building up your credit card debt all
over again.
Assuming none of these problems is a
show-stopper, you still would be ill-advised to accept a proposal from a
solicitor without checking out alternatives. Many soliciting loan providers
favored with a trusting client will price the deal far above the market � just
because they can. You change this mindset when you let a solicitor know that you
are scouting other possibilities.
Refinancing Again to Lower the Rate:
The second part of the proposal is that you will lower the rate by refinancing
again after your credit score improves. But for this to work, you must have the
discipline to avoid building up your credit card debt again. If you can muster
the discipline, the best time to do it is before you refinance the first
time.
With a credit score of 525, you are
in the sub-prime market. You will not only pay a high rate, but your new loan
will have a prepayment penalty to protect the lender against precisely what you
intend to do: raise your credit score and refinance at a lower rate. Because it
is very costly to put sub-prime loans on the books, lenders in this market
require a prepayment penalty covering at least two years.
It would be far better to graduate
to the prime market before refinancing. This will save one set of refinance
costs and avoid a prepayment penalty. To graduate, you need to raise your credit
score by about 100 points. You do this by paying all your bills on time, month
after month. Its boring, but it pays big dividends.
Copyright Jack Guttentag 2004
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