You want to refinance your auto loan, mortgage, or another loan. But you are worried it will hurt your credit score. Discover how refinancing affects your credit score.
Refinancing a loan will temporarily drop your credit score slightly due to the hard inquiry and reduced age of your credit accounts. However, it is frequently a savvy financial decision to refinance a loan.
Discover the specifics about how refinancing a loan will impact your credit score, as well as why you should likely refinance anyway.
How Refinancing Affects Your Credit Score
When you refinance a loan, you will notice a slight drop in your credit score. This is completely normal and something you should be prepared for. The change should, in most cases, be temporary and minor. Even so, it is something to be aware of before refinancing.
Before you can understand how refinancing affects your credit score, you need to make sure you understand what it is.
When you refinance a loan, you take out a new loan that pays off the old loan. The goal here is to give yourself a financial benefit of some sort.
Refinancing is especially popular as a way to take advantage of a lower interest rate. Some people also choose to refinance to extend their loan term. That change will reduce your monthly payments.
You can also consolidate your loans as you refinance. This is when you get a single loan to pay off or replace several loans. Consolidating your loans like this can make it easier to keep track of all your payments. It will also reduce the number of open accounts you have on your credit report.
Why Does Refinancing Hurt Your Credit?
There are two primary reasons that refinancing hurts your credit score, with a few additional factors as well.
One of the main reasons refinancing hurts your credit is that it requires a hard inquiry. Remember that credit checks, including hard inquiries, account for 10% of your credit score.
How to Minimize the Impact
With newer scoring models, multiple hard inquiries only affect your score once, as long as they occur within 14 days of each other. Some scoring models even let you have multiple inquiries within 45 days but only count them as one.
The important thing to remember is that you can’t control which scoring model your future lenders will use. As such, if you apply for refinancing from multiple lenders, do so within two weeks. This will increase the chances of the inquiries only being counted once.
The other major factor is how refinancing impacts the age of your credit accounts. Remember that your average credit account history accounts for 15% of your FICO score.
Then, consider what refinancing involves. You close your old loan and replace it with a new one. This means you will remove one “old” credit account and add a “new” one to your credit report. So, your average account age decreases. This causes a small drop in your credit score.
This Is Not Always the Case – Or It May Be to a Lesser Degree
While most credit scoring models will penalize you for closing old accounts, it is important to note that that is not always the case. Some scoring models will include that closed loan’s payment history, assuming that it was in good standing when you closed it.
How Badly Does Refinancing Hurt Your Credit?
The extent to which refinancing hurts your credit score depends on your credit history. Specifically, it depends on what the parts of your score it affects look like.
So, if you have other accounts in your credit history that are as old or older than the loan you plan to refinance, you may notice a mild impact. By contrast, if you are refinancing a loan from when you were 18 or 19, and most of your other credit history begins five or ten years later, you may notice a larger impact.
The good news is that your score will recover. Over time, the fact that you refinanced should help your credit score by making it easier to pay off your loan. For some people, your credit score may even start to rebound within just a few months. But this depends on your credit history and assumes you make on-time payments toward your new loan.
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Should You Refinance Anyway? Yes (If the Situation Is Right)
Since refinancing temporarily hurts your credit score, it can be confusing whether you should do so anyway. The short answer is yes!
It Helps You Financially
The biggest reason to refinance anyway is that it will help you financially. You will likely end up with a lower interest rate or monthly payments. This should reduce your financial burden, making it easier to save and budget.
It Can Reduce Your Interest Payments and Balance Owed
In many cases, people refinance to get a lower interest payment. Depending on the size of your loan, even a small difference in interest rates will make a significant difference in the overall amount that you owe. But you should always make sure that you will save enough money to make refinancing worth it.
This is most likely the case if you have improved your credit score since you took out the initial loan. It may also be the case if interest rates have dropped since your initial loan.
But Beware, It May Also Increase the Lifetime Balance
If you refinance with the goal of lower monthly payments, be aware that you may end up with a higher overall balance. Remember that interest compounds monthly, so the longer you take to pay your loan, the more interest will accumulate.
You can easily find a calculator to help you check whether this makes sense for you.
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It Can Boost Your On-time Payments
In the long run, refinancing is likely to boost your credit score. This is because refinancing usually lowers your monthly payments, which should make it easier for you to pay on time. Remember that your payment history accounts for 35% of your credit score.
So, refinancing makes it easier for you to keep 35% of your FICO score as high as possible.
It Can Reduce Your Credit Utilization Rate
There’s another way that refinancing can help your credit score in the long run. It can also improve your credit utilization ratio. As a refresher, this ratio is the amount of credit you have available divided by the amount you use. It accounts for 30% of your score.
How does refinancing fit into this? When you refinance your loan, you are more likely to pay it off promptly or at least make progress on it. The more you pay off, the better your credit utilization ratio will be. This is assuming that all of your other credits and loans maintain the same balance.
It Can Reduce the Number of Open Accounts
If you are refinancing and consolidating at the same time, then you may get yet another benefit. The fact that you will have fewer accounts open with balances should improve your credit score.
You Can Take Advantage of Home Equity
Refinancing can also be a way to take advantage of the equity your home has gained, assuming you are refinancing a mortgage. In this case, you would apply for a new loan that is larger than the amount you owe on the previous mortgage. This would give you a sum that you can use for emergency situations.
However, you should always carefully evaluate your options before doing this. First of all, your home must have built equity for this to be feasible. You also need to make sure that you can pay off the new loan with its higher amount. After all, your home will be the collateral.
When to Refinance
As mentioned, there are two likely scenarios when you would refinance: your credit score has improved, or interest rates have lowered. In either of these cases, you would get to take advantage of a lower interest rate on your new loan.
Bonus Tips When Refinancing
The following tips will help you minimize the impact of refinancing on your credit score. They will also help you find the best deal and ensure the process goes smoothly.
Check for the Final Payment on the Old Loan
One of the most commonly overlooked things that you need to do in this scenario is paying attention to your final payment on your old loan.
Your new lender might say you can just skip it since your new loan will pay it off. However, the timing may not be ideal. What happens if the payoff for the old loan arrives after your payment is due? If you don’t do anything, this will affect the 35% of your credit score that reflects your payment history. If you pay attention, you have the chance to catch this and make the payment.
Before you commit to refinancing, confirm approximately how much you will save. Expect refinancing to come with a cost of some sort. For mortgages, for example, the average closing cost is 2% to 6% of the value of the refinance.
Because of this, you want to do some math to confirm that you will save money overall by refinancing.
Think Twice Before Refinancing Federal Student Loans
If the loans in question are federal student loans, think twice before refinancing them. This would turn your federal loans into private loans. That would make you ineligible for any federal loan forgiveness programs.
Refinancing a loan will temporarily drop your credit score because of the hard inquiries and your average account age reduction. Even so, it frequently makes financial sense. This is especially true if it makes it easier for you to make on-time payments, which will boost your credit score.