“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 deal 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: If your credit score improves, you will be able to lower the rate by refinancing again, subject to two provisos: market rates don’t increase materially in the meantime, and you have the discipline to avoid building up your credit-card debt again. But if you can muster the discipline, the best time to do it is before you refinance.

With a credit score of 525, you are in the subprime 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 subprime 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. It’s boring, but it pays big dividends.

How Do You Pay Off a Loan?

“I have come into a bequest and want to pay off my mortgage in full. How exactly do I do that?”

You can’t just send the lender a check, even if you know exactly what the payoff amount is. Lenders have procedural rules about payoffs and you must follow them.

Another reader recently wrote me about her experience. She called the lender to find her balance, calculated interest through the day of payoff, and sent the lender a check. When she examined her account on the Internet some days later, however, the payment had not been credited. So she called again.

She was told that the last payment, no matter what the amount, had to be a cashier’s check or direct funds transfer; it had to be mailed to a different address; and it had to include an additional $50 to reimburse the lender for a payoff statement and for handling the paperwork at the county deed register office. Had she not called, she would have been delinquent.

The moral: before proceeding, call the lender to learn the drill.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.


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