Clean up your credit to get best refinancing rates

Q: I just bought a home in March with bad credit. I got an 80/20 loan, of which $69,000 is financed at 8 percent and $17,000 is financed at 10 percent. Both of these loans are 5-year adjustable rate mortgages (ARMs).
 

I have not resolved all my credit issues, but I desperately need to refinance these loans and consolidate my payments. My credit isn't that bad. I've only got a couple of collections on my credit report. I'm a first-time homeowner and I don't know what to do. Any advice?

A: Considering that you haven't resolved all your credit issues and you needed 100 percent financing, you were lucky to be able to buy a house at all.

Although the interest rates on your two loans seem high — and they are high compared with the rates borrowers with top credit scores are getting — they may be legitimate for someone who has collections or late payments on his credit report and is financing 100 percent of the purchase price.

If you need to refinance your loans, schedule appointments with major lenders in your area to see what they can do for you. Pull a copy of your credit report and score (myFICO.com, $12.95) to see where your score is and how you can improve it. Take your credit score with you to the appointments so lenders won't have to pull copies. (When lenders pull copies of your credit report, this can lower your credit score even further unless you refinance within 30 days.)

If local lenders can't help you, spend the next six months or a year working to clear your credit history of negative information. Six months or a year of on-time payments will boost your credit score. Then you should be able to get better rates.

Q: I'm considering borrowing from my 401(k) for a down payment on a house. This is a loan, not a withdrawal. I have to pay it back at 1 percent over prime. The plan has a provision that loans for down payments can be repaid over a period of up to 20 years.

Using such a loan would allow me to purchase a new home without selling my current home. I'd like to either lease the new home or move in for a few years, sell it, and take the profit tax free. Is this a good idea?

A: My feeling is, a retirement account should not be used like a checkbook. Instead, it should be the place you go when you're out of other options. When you borrow against your retirement account, even if you pay yourself back with interest, you're missing out on total growth of the account.

What you're proposing is actually is a bit different. You're borrowing from your 401(k) to invest in real estate. Essentially, you're trading one type of investment for another, rather than using the money to pay off debt, buy a boat, or take a trip around the world. This could work out well, provided you understand the pitfalls.

First, when you borrow from a 401(k), you must continue to work at the job to enjoy the leisurely payback you've arranged. If you lose your job, or leave, you may have to pay back the entire amount within 60 days, or sooner.

Second, real estate doesn't always appreciate in value, and investing in real estate doesn't always work out well. Your property could go down in value, or the house could be vacant for an extended period of time. If you lose the property, you'll likely lose your investment, which means your retirement will take a double hit (because you're already losing out on some growth in the 401(k)).

Finally, investing in real estate requires a much greater investment of time and cash than, for example, owning shares in an index fund. You'll have the costs of purchase and sale, fixing up and maintaining the house (more expensive when you have renters than if you live there yourself) and property taxes.

If you want to keep the profits tax-free, you'll have to live in the home as a primary residence for two of the five years prior to selling. If you lease the property right after you buy, it won't qualify as a primary residence until you move in,

Rather than use your retirement funds, I'd rather see you take out a home equity loan against your current home to fund the down payment.

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Ilyce R. Glink's latest book is "The REALLY Useful Guide To Working Smarter Not Harder." To find out how to get a free copy, go to Quill.com/smartbook. If you have questions, write: Real Estate Matters Syndicate, P.O. Box 366, Glencoe, IL 60022 or contact Glink through her Web site: www.thinkglink.com.

© 2003 by Ilyce R. Glink

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