Refinancing your mortgage, auto loan, personal loans, or other debt can help lower your monthly payments or give you access to better interest rates. But, before you explore this option, you should understand the refinancing process and its consequences on your credit scores. Here’s a breakdown of how refinancing works, the various ways it can affect your credit, and what to consider before using this strategy for debt management.
- When you refinance a loan, you take out a new loan to pay off an old one. The new loan will have different terms and conditions, such as a different interest rate or time span.
- While refinancing may hurt your credit in the short term, when done strategically, refinancing can put you in a better financial situation than before.
- There are different scenarios where refinancing makes sense depending on the type of loan you want to refinance.
Refinancing and Your Credit
What is Refinancing?
Refinancing is the process of obtaining a new loan to pay off an existing balance. How you approach refinancing will depend on what type of debt you are trying to refinance, but common reasons why people do so include:
- To get a lower interest rate
- To shorten the loan term
- To consolidate debt
- To take cash out of the home equity
- To fix a bad credit score
- Because they are upside down on their mortgage
Because refinancing is essentially replacing an existing loan with a new loan under different terms and conditions, this decision should not get taken lightly. There are some risks associated with this action. For example, if you extend the length of your loan term when you refinance, you may end up paying more in total interest over the life of the loan. And if there is little or no equity left in your home after taking out new financing for your mortgage, there may not be many benefits in terms of savings on monthly payments.
First, Check Your Credit Reports
Before submitting any refinancing applications, review your credit reports to ensure the information is accurate and up-to-date. Credit reports are important documents that detail your credit history. They include information such as how much debt you have, how often you make payments on time, and if you have any bankruptcies or liens.
There are a few ways to check your credit reports. You can go through one of the three major credit bureaus (Equifax, Experian, or TransUnion), use a service like Credit Karma, or request a free copy at AnnualCreditReport.com. All of these services allow you to view your reports at no charge.
If you find any errors, dispute them immediately. You can do this by contacting the bureau that issued the report or using one of the dispute resolution services offered by credit monitoring websites. Fixing errors on your credit report can improve your score and boost your chances of getting approved for loans and other types of financial tools in the future.
How Refinancing Can Hurt Your Credit Score
Multiple Hard Credit Inquiries
One factor that can negatively influence your credit score is the number of hard inquiries on your reports. When you apply for a loan, the lender will pull a hard credit inquiry on your credit to verify your creditworthiness. Each time a creditor does this, it results in one hard inquiry, which can temporarily take up to 5 points off your credit score and stays on your credit reports for 2 years.
Too many hard inquiries can start to add up, so be mindful of how often you apply for new lines of credit and the timeframes. The good news is that soft inquiries – those made by companies checking whether you might be interested in their products – do not affect your credit scores. So if you are shopping around for the best deals, go ahead and check with multiple lenders; just make sure they pull soft reports rather than hard ones.
Luckily, you can minimize the impact of hard inquiries by submitting all your loan applications within a short window. Depending on the credit scoring model, applying to multiple lenders within a 14-day to 45-day period will get treated as one inquiry instead of multiple hard inquiries, minimizing the hit to your credit. On the other hand, applying for various loans over several months could lead to a lasting negative effect on your credit.
Old Debt Becomes New Debt
The length of your credit history makes up 15% of your credit score calculations, so the older your credit, the better. From a lender’s perspective, this means you have been using credit for a long time and know how to manage your finances responsibly. In other words, creditors will look at this number to see how likely you are to pay them back on time and give you better terms if you have an established history of borrowing money and paying it back responsibly.
When you refinance a loan or multiple loans, you effectively shorten the average age of your credit accounts. If your current mortgage is one of your oldest credit accounts, for example, refinancing your mortgage can hurt your score and impact your ability to get approved for a loan in the future.
Multiple Loan Applications
Applying for several different types of loans, such as a mortgage refinance, personal loan, and credit card can drive your credit score down more than simply doing a mortgage refinance by itself. Additionally, the impact of closing an account will depend on its size and age.
As mentioned earlier, lenders like to see long-term credit accounts in good standing. So, when you refinance a loan, your good track record ends there. You end up incurring “new” debt and closing a long-standing account, which will affect your credit score. However, because payment history makes up 35% of your credit score, some credit scoring models will factor in closed accounts in good standing and lessen the impact on your credit. As you pay down your balance and rebuild a solid payment history, your credit should gradually recover.
When Should You Refinance a Loan?
There is no one definitive answer to the question of when you should refinance a loan. However, the ideal time to refinance can depend on the type of loan you are refinancing.
Refinancing a Mortgage
There are a lot of factors to consider when deciding whether or not to refinance your mortgage. But, generally, the best time to refinance is when you can get a lower interest rate than you are currently paying or if it lowers your monthly payments.
If you have an adjustable-rate mortgage, for example, and interest rates have gone down since you took out your loan, refinancing could save you money down the line. You might also want to refinance if you can shorten your loan term – for example, from 30 years to 15 years – which will reduce the total amount of interest you pay over the term of the loan.
If you extend payments out longer from refinancing, interest will accrue for a longer period even though your monthly payment was reduced. Additionally, keep in mind that there are costs associated with refinancing: closing costs (which can amount to several thousand dollars), origination fees charged by lenders, appraisal costs, title insurance, and credit reporting fees. These costs typically range between 2% to 6% of the loan, so make sure that any savings from refinancing will outweigh these expenses. We recommend using a refinance calculator to determine your break-even point.
If you decide to refinance, pay attention to when and what payments are due for your old vs. new loan. If the new loan’s payoff date arrives after the last payment on your previous mortgage is due and you forget to pay, your credit could get dinged for late payment.
If you are not sure when you should refinance your mortgage, do your due diligence to find the best timing. Alternatively, you can work with a mortgage refinance lender to see if refinancing is a viable option.
Refinancing an Auto Loan
There are a few key factors to consider when deciding whether or not to refinance your car loan. The first is how long you have been making payments on the loan. For example, if you have been making payments for less than 36 months, you may not yet have built up enough equity in the vehicle to make refinancing worthwhile.
Another factor is how much money you could save by refinancing. If you can get access to lower interest rates than what was available when you initially financed the car, it may be worth refinancing. Or, if your credit score has improved since you first bought the car and you have been making regular, on-time payments, you may qualify for better rates. But, make sure to factor in any fees involved with the process to ensure the new rate is low enough that your total costs do not significantly increase.
Finally, consider your current financial situation and whether or not you can afford the new monthly payment amount. You may want to refinance simply to reduce your monthly costs. However, as with other loans, refinancing for a longer-term loan could increase the total amount you pay for your car depending on the length of time you increase the loan by.
If you have crunched the numbers and all of these factors point towards refinancing your car loan, go ahead and do it! You could save yourself hundreds of dollars over the life of the loan.
Refinancing a Student Loan
Finding the right time to refinance a student loan will depend on whether it is a federal or private loan. If you have federal student loans, the tradeoff is that you will need to forego any borrower benefits you have during repayments, such as loan forgiveness or an income-driven repayment plan. Hence, refinancing private student loans usually make more sense because they do not come with the same benefits as federal student loans.
With student loan refinancing, there are several situations where you may want to refinance:
- You have high and/or variable interest rates that can cause your interest to snowball in the future.
- Your credit score has gone up since you first took out your student loans, so now you qualify for more competitive rates.
- Refinancing with a lower rate will save you money over the loan term.
- Most of your student loans are private, so you will not lose any of the benefits that federal loans come with.
- Interest rates now are much lower than when you first applied.
How to Prevent Refinancing from Hurting Your Credit
By planning and creating a strategy based on your financial situation, you can ensure that refinancing will not adversely impact your credit and overall financial health. Review your credit reports and dispute errors ahead of time. Keep making on-time payments for your loans and shop around for the best rates and terms. Spend within your means and budget accordingly. As long as you take preventative measures before refinancing, you can save time and money and ensure that the refinancing process goes smoothly.
The Bottom Line
Before making the jump, here are some things you’ll need to consider when refinancing:
- Your current financial situation Do you have an emergency fund? What is your credit score? How much debt do you currently have? These are all important factors that will impact your ability to refinance.
- The current market conditions When interest rates are at historic lows, that may be a good time for you to refinance. However, if interest rates go up while you’re in the middle of the refinancing process, it could end up costing more in the long run than if you had waited until later.
- The terms of your existing loan Make sure that any new loan will have better terms than what’s currently available on your old loan (i.e. lower interest rate, shorter-term). If not, there may not be much point in refinancing.