Refinancing your loan can help you reduce your loan payments if you can snag a lower interest rate or extend your loan term. However, your credit score may take a slight hit when you refinance. But if the benefits of refinancing outweigh the drawbacks, you may still want to consider it. Ultimately, the decision depends on your unique financial situation.
Key Points
- Refinancing a loan can cause your credit score to decrease temporarily.
- Refinancing may lead to hard inquiries on your credit report and a reduction in the age of your credit accounts, which can negatively affect your credit score
Does Refinancing Affect Your Credit Scores?
Refinancing can have a negative effect on your credit scores. However, this effect is usually short-lived. In fact, depending on how you manage your loan, you could actually help your credit profile over the long run, which we’ll get into later.
How Does Refinancing Affect Your Credit Scores?
While there are many benefits to refinancing, it can also negatively affect your credit score in the following ways:
Hard Credit Inquiries
Any time you apply for a loan — including when you apply for a refinance — the lender may check your credit report. This is referred to as a “hard credit inquiry”, which can cause your credit score to dip, usually temporarily.
Even if you apply with multiple lenders to compare offers, all the hard inquires may count as only one inquiry. However, this is only true for certain types of loans you’re trying to refinance , such as a mortgage. Moreover, for multiple hard inquires to count as one, they usually must all take place within a certain timeframe, generally between 14 to 45 days.
| Note: Keep in mind that when you pull your own credit report, this counts as a soft credit inquiry. These types of inquiries do not impact your credit score. |
Credit History
By refinancing, your old loan will be closed, and a new loan will be opened. This can cause the average age of all your credit accounts to decrease, which may negatively impact your credit score.
Keep in mind that the gravity of this impact depends on the credit scoring model used to calculate your credit score. Some models will include closed accounts in the average age of credit accounts, while others may put very little emphasis on it
Payment History
Some scoring models will consider the payment history of a closed account for up to 10 years. That means if you’ve had a positive history of payments on the loan you’re closing, these payments may still be considered as part of your credit score calculation even years after you close it.
However, some scoring models do not include this information. If the scoring model in your case does not factor in timely payments from your old loan that you’re replacing through a refinance, your credit score could take a hit as a result.
Luckily, your new loan will be incorporated into your payment history moving forward.
| What Is Refinancing? Refinancing is the process of paying off your existing loan with a new loan, usually with a different rate and terms. You may choose to refinance as a way to secure a lower interest rate, a different term length or both. A variety of loans have refinancing options, such as mortgages, auto loans, student loans, and personal loans. |
Benefits Of Refinancing
Below are several reasons why you may want to consider refinancing your loan:
Lower Interest Rates
Through refinancing, it’s possible to get a lower interest rate than what you’re currently paying, especially if your credit and finances have improved since the last time you applied. Lower interest is a huge benefit because you’ll pay less toward interest, which can lead to significant savings over the life of the loan. This can also mean lower installment payments, depending on how you restructure your new loan.
Moreover, if you have a variable interest rate, you may be able to switch to a fixed rate when you refinance. This may be appealing to those who have a strict budget and want to have steady payments. You can also o the opposite and switch from a fixed-rate to a variable-rate loan if you prefer.
Extending Repayment Term
When you refinance, you may be able to shorten or extend your loan term, depending on what you’re looking for.
- Extending your loan term – By lengthening the repayment term, you’ll have more time to pay off your loan. This can translate into smaller installment payments, which may fit better within your budget.
- Shortening your loan term – If you have a higher income to cover larger payments, you may want to shorten your loan term. You can make this change through a refinance. While this will increase your loan payments, you’ll be able to repay the loan quicker and save money in interest payments.
Larger Loan Amount
For debt consolidation purposes, refinancing can help you attain a larger loan balance to cover any additional costs you may now have. If your finances are healthy, you may be able to qualify for a bigger loan amount today compared to when you first took out your loan.
You can then use these funds to pay off much of your existing debt, including high-interest debt. This can save you money and make it easier for you to manage your debt.
How To Boost Your Credit After Refinancing
Your financial habits can have a big impact on your credit scores. If your score dips after applying for a refinance, there are several things you can do to help bring your score back up as quickly as possible:
Check Your Credit Reports For Errors
It’s a good idea to check your credit report at least once a year to make sure everything on there is accurate. Any errors on your credit report could be unfairly pulling your credit score down. If you notice any mistakes, have them disputed right away.
Keep Up With Your New Loan Payments
Since your payment history holds the most weight when it comes to calculating your credit score, you want to make sure to make consistent payments towards repaying your new loan after you refinance. Every on-time payment you make will go a long way at helping increase your score over time.
Keep Your Credit Utilization Ratio Low
Your credit utilization ratio refers to how much you spend on credit relative to your credit limit. To give your credit score a boost, make sure to keep your credit expenditures less than 30% of your credit limit. So, for instance, if you have a credit card with a limit of $10,000, don’t spend any more than $3,000 against that credit ($10,000 x 30%).
Should You Ever Avoid Refinancing?
There are two situations where you may not want to refinance. It’s important to remember that everyone’s financial situation is unique. What works for one person may not work for another.
Be sure to exercise judgment as a part of your decision-making process. Here are a couple of cases in which refinancing may not be worth it
Your Credit Score Is Lagging
Ideally, you’ll want to wait until you have a stronger credit score before considering a refinance. That’s because a higher score could qualify you for a lower interest rate on a new loan. But if your credit score is currently not high enough to get you a better rate, now might not be the right time to refinance your loan as you may get stuck with a more expensive loan.
The Costs Of Refinancing Outweigh The Potential Savings
Refinancing can save you money if you can snag a lower interest rate or even shorten your loan term. But if the costs associated with the refinance are high, it could take you a long time to reach the break-even point between potential interest savings and refinancing fees.
Further, there may be penalty fees associated with breaking your loan contract early before it’s due. If there are fees to pay, you’ll want to check your loan contract to see how much they are. Again, the potential savings in interest by refinancing may not be enough to justify all the costs., Be sure to crunch the numbers first.
You’re Offered Poor Refinancing Options
Before moving forward with a refinancing option, deep dive into the offers you’ve been given to determine if they’ll really benefit you. Check out the interest rate, fees, and repayment terms to verify if they’ll help you save money or streamline your finances before refinancing your loan.
Is Extending Your Loan Term The Right Choice?
As mentioned, one big reason why some consumers may choose to refinance their loan is to extend their loan term. Doing so can lower your loan payments. However, there are a couple of trade-offs to extending your loan term when you refinance
- You’ll be in debt for longer — By extending your loan term, you’ll have to continue paying your loan for a longer period of time. That means it will take longer for you to become debt-free.
- You’ll owe more in interest — A longer loan term typically means more interest paid over the life of the loan. Depending on your loan amount, interest rate, and term length, this could translate into thousands of dollars extra, or more.
Bottom Line
Your credit score might take a hit when you refinance, but that doesn’t mean it’s not worth it. The whole point of having a good credit score is to take advantage of financial benefits, including the low-interest rates and cost savings that come with refinancing. If you have the opportunity to get yourself a loan with a lower rate and better terms, the temporary credit score hit could be worth it.
