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How a Simple Mortgage Refinance Saved Me From Credit Collapse
I first learned about refinancing a home several years into my first stint as a homeowner. At age 25, I decided to use the money I’d managed to save from my first job as a copy editor and buy a condo. No, I wasn’t well-off at the time, but this was before the housing crisis, when mortgages were basically being handed out like Halloween candy.
Immediately after college, I’d moved into an apartment in Weehawken, N.J., and began working at a newspaper in Jersey City. When my landlord notified tenants that he planned to double the rent and empty out the building, I slunk back to my parents’ house and was allowed to live there for a year. It gave me enough time to save up for a modest (under 20%) down payment on a one-bedroom condo in Verona, N.J., but not without signing onto a five-year, adjustable-rate mortgage with a rate of nearly 6.6%.
Even as I signed the mortgage, I had a feeling it was a really bad idea. I was four years into a 10-year payment schedule on my student loans, and I wasn’t making sound financial decisions at that point in time. I was driving a 15-year-old Ford Taurus that cost me $500 every time it went in for repairs when an accident not only raised my insurance rates, but forced me into my second Ford Taurus – this one 12 years old. If you need further evidence of my mid-20s financial foolishness, consider this: I purchased it with a cash advance on a credit card that I’d been issued through my family’s credit union of choice.
- Read more: 10 Common Money Mistakes 20-Somethings Make
I managed to open a second credit card – an American Express Blue with revolving credit – largely because I kept paying my mortgage and student loan on time. But I’d already cost myself 5% of the value of a terrible used car just by taking out a cash advance, and I was inflicting higher interest rates on myself thanks to my bloated credit card bill (of which I was paying little more than the minimum).
Little more than three years into my mortgage, I knew I needed help. I asked family members who’d recently refinanced their homes how they did it, and they pointed me toward a broker who’d come to their homes and reviewed their finances with them.
I had this broker come over to the condo and laid bare my shame: My mortgage, my student loan balance, my credit card bills, and my monthly payments, all fanned out on my kitchen table. He showed me how much equity I’d built in the condo just by making payments and pointed out that my student loan balances were actually much lower than when I’d bought the condo for the same reason.
He noted that my existing home equity could completely cover my outstanding bills, and — because mortgage rates had dropped by more than a point since I first bought the home — a refinance could blend it all into one monthly payment that was lower than my mortgage payment to that point.
Refinancing and Your Credit
That would take me back to zero, but it was going to be difficult to stay there if I kept treating my credit like free money.
It was at that kitchen table that the broker showed me the five components of your FICO credit score.
The biggest slice, 35% of your credit score, is your payment history, which was working in my favor after several years of on-time payments. However, the next biggest piece is credit utilization, or how much of your available credit limits you’ve used up. That accounts for a whopping 30% of your credit score, and with my credit card balances far above the 25% to 30% usage threshold that experts recommend staying well shy of, credit utilization was roughing up my score with impunity.
Another 15% of your credit score comes down to the age of your credit history, and mine was still less than a decade old and not exactly untarnished. But refinancing could help change the biggest negatives to positives. As credit card expert John Ulzheimer points out, credit card balances are considered riskier “revolving debt” that counts against your utilization ratio, while a refinanced mortgage is an installment account secured by an asset – basically, if you don’t pay the mortgage, the mortgage lender can take the house back to cover its losses.
“When you carry a high percentage of credit card debt compared to your credit card limits, your credit scores are going to almost certainly begin to trend downward,” Ulzheimer says, while a large mortgage balance won’t have much of an impact on your utilization ratio.
So a refinanced mortgage isn’t as much of a credit risk for a lender as a weighty credit card balance. But there’s a lot more at stake for you if you run up debt again and can’t make the payments.
That makes the next step after refinancing and debt consolidation the most important. For me, it meant putting my revolving-debt credit cards through a shredder and leaving myself with only a debit card and an American Express green card, which requires cardholders to pay their balance monthly.
A little more than a year after I refinanced, I was working at a newspaper in New York that had a sister paper in Boston. My sister was planning to move up there, and several of my friends from college had already settled there after school. I checked with a real estate agent to see how quickly my condo could sell, and discovered its position near public transit to Manhattan and the minor changes and repairs I’d made to the place (paint, light fixtures, and a new stove and dishwasher to replace their 1970s predecessors) made it more valuable than when I’d bought it.
To my surprise, the best offer came in at $84,000 more than I’d paid for it, and I moved up to Boston a month later with zero debt and a nest egg to boot. That surplus became my emergency fund and, while I was fortunate enough to never have to make substantial withdrawals, it made it much easier not to turn to revolving credit cards in a pinch. Years later, after I’d met someone and married, that emergency fund came along with us and served as a portion of the down payment on our new house.
To this day, a portion of each month’s pay and any tax refunds we receive goes directly into that emergency fund. It’s the legacy of a shaky real estate purchase, but a reminder of the refinancing and reassessment that built our sturdy financial foundation.