Should You Refinance a Mortgage to Improve Credit?

17 May 2004, revised July 6, 2007, Reviewed October 27, 2010

"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?"

I think that it is foolish to refinance in order to improve your credit score so that you can refinance again. Improve your credit score first, then refinance.

Going ahead with this deal would also 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 at a Higher Rate May Not Lower Costs

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. My debt consolidation calculators 1b and 1c 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. See Pros and Cons of Debt Consolidation.

Dangers in Responding to a Solicitation

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. See Mortgage Leads: Are You One? 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.

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