How one homeowner saved big by improving his credit score

Jeffrey Green bought his home in September 2005. An engineer in his late 40s, Green purchased his 2,500-square foot, 4-bed, 2.5-bath home in the Los Angeles area with a $525,000 loan. He received an interest rate of 6 percent on a 30-year fixed, interest-only loan.

According to the Federal Deposit Insurance Corporation website, interest-only loans allow homeowners to make payments toward the interest only (nothing is paid toward the principal) for a set period of time - usually three to 10 years. After that time, you must start making payments toward both the principal and the interest, the FDIC website explains.

Due to the interest-only loan, Green was making payments of $2,625 a month toward his mortgage, opposed to the $3,147 a month he would have paid with a traditional loan. That's a difference of $522.64.

Green chose an interest-only loan to have lower initial payments, says Brian Vosberg, a financial advisor and licensed mortgage broker, who handled Green's refinancing.

"At the time, based on his income, a traditional loan payment would have put pressure on his budget," Vosberg explains.

Green's plan was to refinance to a traditional mortgage when his income increased.

[Ready to refinance your mortgage? Click to compare interest rates from multiple lenders.]

Refinancing Roadblock: Low Credit Score

When May 2013 came around and interest rates were low - an average of 3.54 percent (according to Freddie Mac) - Green was ready to refinance.

At the time, his credit score was 643, which, according to Vosberg, is less than ideal for a mortgage.

"If he went with the refinance at that credit score, the interest rate would have been 4.875 percent for a 30-year fixed loan," says Vosberg. That means he would have received an interest rate that was more than 1 percent higher than the average.

While an interest rate of under 5 percent was an improvement over his current rate, Vosberg thought Green could get a better rate if he improved his credit score. An excellent credit score to have when refinancing is 740 and higher, according to Vosberg.

Vosberg says credit scores are one of the ways that mortgage companies gauge the creditworthiness of the borrower.

"The lower the score, the more risk the lender takes on," Vosberg says. And when taking on higher risk, the lender compensates by charging higher interest rates, Vosberg explains. And this is exactly why Green was quoted such a high interest rate.

How he Improved his Credit Score

The first step in repairing Green's credit score was to take a hard look at his finances, Vosberg says. He says the reason for Green's low credit score was immediately obvious: credit card debt.

"[Green] had four credit cards maxed out, carrying over $50,000 in credit card debt," Vosberg explains.

And while paying off the credit card debt was the apparent next step, Vosberg says paying off $50,000 would have taken several years, and Green would run the risk of interest rates increasing.

[Click to compare interest rates from multiple lenders now.]

The solution? "We took a loan from his 401k for $35,000 and immediately paid off two credit cards and reduced the balance of the other two by more than half," Vosberg says.

While it's not always a good idea to take money out of a 401k to pay for your mortgage, it made sense in Green's case as the interest rates on his credit cards were high. Paying off credit card debt - instead of having the money sit in his retirement account - actually saved him a lot of money in the long run, says Vosberg.

Then, over the following four months, Green was able to pay an additional $10,000 towards his debt using cash savings and income.

By September 2013, Green's credit score jumped up to 722 - an improvement of a whopping 79 points over four months.

[Time to refinance to a lower interest rate? Click to see how much you can save now.]

With the higher score in hand, Green was able to refinance his home with an interest rate of 4.25 percent - instead of the initial 4.875 percent he was quoted with his lower credit score. And while the difference might not sound like much, an improved credit score saved Green an additional $200 per month on his new 30-year fixed loan of $525,000, according to Vosberg.

What's even better is that his new monthly payment was $2,582.68 - $42 less than he was paying with the interest-only loan.

Thanks to the refinance - and his improved credit score - Green is now making payments towards the interest and principal of the loan, while also managing to reduce his monthly payment.