Anyone who holds a loan may want to refinance it for the associated benefits that come along with the offer. However, your credit scores may take a slight hit when you refinance. But if the benefits of refinancing outweigh the downfall, you should definitely still consider it. Ultimately, the decision depends on your unique financial situation.
What Is Refinancing?
Refinancing is the process of paying off your existing loan with a new loan. A variety of loans have refinancing options, such as mortgages, auto loans, student loans, and personal loans.
It may seem redundant to refinance a loan, why bother taking out a new loan for an old loan? There are actually several advantages to refinancing as loans can become less beneficial to you over time, especially as better options become available to you.
Benefits Of Refinancing
Below are several reasons why people are motivated to refinance their loans:
Lower Interest Rates
Through refinancing, it is possible to get a lower interest rate than your current loan, especially if your credit and finances have improved since the last time you applied. Lower interest is a huge benefit because you won’t have to pay as much each period, which can lead to high savings.
Moreover, if you have an adjustable interest rate, you may be able to get a fixed interest rate when you refinancing. This may be appealing to those who have a strict budget and want to have steady payments.
Some refinancing offers can reduce fees related to your loan which can save you money in the long run.
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 Loan Term – By increasing the repayment term, you will be making payments for a longer period of time but each payment will be smaller and more affordable. This allows the individual to use their excess money elsewhere.
- Shortening Loan Term – If you have a higher income to cover larger payments, you may want to shorten your loan term. While this will increase your loan payments, you’ll be able to repay the loan quicker.
For debt consolidation purposes, refinancing can help you attain a larger loan balance to cover any additional costs you may now have.
Should You Refinance Your Loan?
Before you consider refinancing a loan, you should check if your credit has improved since your approval for the initial loan. Lenders will be pulling your report as a part of their approval process for refinancing to ensure that you are a creditworthy borrower.
Your lender will offer better refinancing terms if your credit has improved because it demonstrates that you’ve been paying your bills and debts on time. Be sure to clean up your credit report by disputing errors and boosting your scores in whatever way you can before potential lenders see it.
What Happens To Your Credit When You Refinance?
While there are many benefits to refinancing, it can also negatively affect your credit scores. In fact, refinancing can affect your credit in different ways.
Any time you apply for a loan, the lender may check your credit report which contributes to your hard credit inquiry count. The number of hard inquiries can cause your credit scores to dip, but it depends on how many there are and how close together the inquiries were made.
Fortunately, hard inquiries will not significantly impact your credit scores, they will only have a slight impact. Part of the refinancing process is shopping around for the best interest rates and other offers. This will require a number of hard inquiries, but so long as they all occur within 45 days the inquiries will only count as one.
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 scores.
By refinancing, your old loan will be closed using the funds from the new loan. This can cause your average age of credit accounts to decrease which may negatively impact your credit scores.
Keep in mind that the gravity of this impact depends on the scoring model, some models will include closed accounts in the average age of credit accounts while others won’t.
Some scoring models will consider the payment history of a closed account for up to ten years but others don’t. If a scoring model does consider the payment history of a closed account, it may not be weighted as high as the payment history of open accounts. Because payment history is heavily factored into your credit score, you may experience a sudden blow as a result of a closed account.
Luckily, your new loan will be incorporated into your payment history moving forward. To ensure that your credit can go nowhere but up, make sure to manage your new loan effectively by not missing payments or paying late.
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, foregoing something small now for an immense benefit in the future could be worth it.
When You’re Thinking About Applying For A New Loan
If you are applying for a new loan, in addition to the current one you have that you’d like to refinance, you should think twice before refinancing your current loan. You don’t want to put your new loan at risk of a higher interest rate or even getting denied in exchange for refinancing your current loan. This doesn’t mean you can’t refinance at all, just hold off until you get your new loan and then move forward with refinancing.
Timing Matters When Refinancing A Loan
Also, if you are planning to refinance multiple loans, make sure to refinance the loan that will give you the most benefits first. For example, you should refinance your mortgage before your car loan because you will get much more out of it. From there, you can work your way down your list of loans.
When 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 make you better off or not. It’s likely that you’ll get a lower interest rate or monthly payment, but be sure to consider what the tradeoff is.
Is Extending Your Term The Right Choice?
Part of a refinancing deal is usually extending the loan term which is how the loan payments are lower, but it also means it will take longer for you to pay off the loan. The payments at the beginning of your refinanced loan will be mostly made up of interest, leading your total interest costs for the asset to be higher. Be sure to read the fine print, lenders may make it seem like you’re getting a better deal when in actuality you’re paying more when extending your term.
Are Your Losing Specific Conditions You Benefit From?
Lastly, consider qualitative factors such as the benefits that come with certain lenders. Take student loans as an example. If you’re trying to refinance your student loan and you’re considering moving away from the government to a private lender, you’re giving up the benefits of government debt. Private companies may not be as lenient about payments and terms which could hurt you down the road.
The Refinancing Trade-Off
Your credit scores might take a hit when you refinance, but that doesn’t mean that it’s not worth it. The whole point of having a good credit score is to take advantage of the financial benefits, including the low-interest rates and cost savings that come with refinancing. If you have the opportunity to get yourself a better loan and put yourself in a better position, by all means, take the opportunity.