So, you're thinking about refinancing your loan or mortgage. It's like swapping your old loan with a shiny new one that has better terms — for example, a lower interest rate or more manageable monthly payments. That sounds like a smart money move, right? It can be, for the most part, but it's still important to know how this can affect your credit score.
In this article, we'll unravel the question of how refinancing loans or mortgages might affect your credit.
What is credit and refinancing?
Before diving into the intersection of credit scores and refinancing, let's define some of the key terms:
Credit score: Picture your credit score as a report card on how well you handle money and debt. It's a number that shows how creditworthy you are. Banks and other lenders sneak a peek at this before deciding whether to lend you money. The higher your score (with the FICO model going up to 850), the more lenders may trust you with their cash.
Credit report: This is like your financial diary. Credit bureaus (like Experian, Equifax, and TransUnion) keep track of all your credit history. It's got all the details on how well you've been paying your bills, how much you owe, and more.
Lenders and borrowers: In the world of loans and mortgages, a lender is like your rich friend (or bank or credit union) who lends you money, and you're the borrower who has to pay it back.
Refinancing: This is like trading in your old loan for a better one. With a refinance, you take out a new loan to pay off your current loan or mortgage. People often do this to get better terms, like a lower interest rate or a better payment plan. Done well, this switch can save you a pretty penny over time.
What are credit inquiries in refinancing?
When you’re refinancing, lenders will perform a credit check or a hard inquiry on your credit report to determine if you can be trusted with their funds. This step is crucial for them to determine if you, as a borrower, would be at risk of not paying off your loan.
A hard credit inquiry involves a thorough check by a lender, typically when you're applying for credit, such as a loan or credit card. This type of inquiry may slightly lower your credit score by a few points and can remain on your credit report for two years.
It's important to know about the concept of rate shopping. Within a certain short period, usually 14 to 45 days, depending on the credit scoring model, multiple hard inquiries by different lenders for the same type of credit are usually treated as a single inquiry. This time frame allows you to shop around for the best loan terms without significantly harming your credit score.
These first steps set the stage for understanding how the act of refinancing can affect your credit. As we delve deeper, we'll discuss specific impacts and how to mitigate any potential negative effects.
How can refinancing affect my credit score?
When you refinance a loan, there are several factors that could potentially affect your credit score. These include the following:
- New credit inquiry: As mentioned earlier, each credit application can lead to a hard credit inquiry, which may cause a slight, temporary dip in your credit score.
- Change in average age of credit: When you refinance, the new loan becomes the newest account on your credit report, potentially lowering the average age of your credit accounts and possibly your credit score.
- Closed account record: Refinancing results in the original loan being paid off and closed. If this was an old loan, it could reduce the age of your credit history.
- New loan account: The addition of a new credit account increases your overall credit mix, which can positively affect your credit score, provided it's managed well.
How do I refinance different types of loans?
The process of refinancing can vary depending on the type of loan you're refinancing. For instance, mortgage refinancing typically involves a hard credit inquiry and origination fees, both of which should be considered when evaluating the overall financial benefits. Whether you’re refinancing student loans, auto loans, credit card debt, or personal loans, the process is similar. First, consider how much money you’ll need to borrow in order to pay off your existing loan.
Then, check your free credit report to make sure your credit score is in good standing, and shop around for the best rates. Look for the factors that make sense for you, such as lower loan payments or better interest rates.
Once you find a loan that offers you the best terms, fill out a loan application. Sign on the dotted line, and you’ll have refinanced your loan.
However, before you make it official, it’s important to make sure you’re aware of all the moving parts involved. For instance, federal student loans that are refinanced through a private lender lose federal protections and benefits. As with any important financial decision, it doesn’t hurt to get the opinion of a professional before committing to a refinance.
How can I reduce the impact of refinancing on my credit score?
While it's clear refinancing can affect your credit, there are ways to help keep your credit in good standing. These include:
- Rate shopping: This is your time to shop around and try to find the best rates, but do it quickly. You have 14 to 45 days (depending on the loan) to compare rates without having multiple hard inquiries on your report.
- On-time payments: If you’ve borrowed money, be sure to pay it back on time every month. When you miss payments, it shows as a big red flag. Your payment history is the most influential factor in your credit score.
- Credit utilization ratio: How much of your available credit are you using? Credit utilization is a percentage that describes how much credit you’re using compared to what’s available to you. Keeping this number low can help your credit score remain in good standing.
- Maintain a mix of credit: A lender wants to see that you’re living life and managing finances responsibly. This can be done by having multiple smaller credit types, like a car payment, a credit card, and a utility payment. This shows responsibility across the board.
- Monitor your credit: Take a look at your credit from time to time, and make sure mistakes or missed accounts don’t appear. Catching any mistakes early can save you the hassle of trying to remove the effects of those mistakes later on.
Other factors to consider when refinancing
In addition to understanding how refinancing affects your credit, there are other things to keep in mind. These include:
- Closing costs: Refinancing often comes with closing costs, or added fees. Be sure to have potential cash on hand, or talk to your lender about rolling those fees into your loan.
- Origination fees: Some lenders may charge an origination fee to process a new loan, so it’s important to include this in your calculations.
- Refinanced loan terms: While a lower monthly payment may sound attractive, ensure it doesn't come at the expense of a much longer loan term, which could mean you end up paying more in interest over time.
The bottom line
Refinancing can be a useful tool in your personal finance arsenal, allowing you to obtain lower interest rates and potentially saving you money. However, it's essential to understand how it can impact your credit score. Carefully consider all aspects, including the potential credit implications and other costs associated with refinancing.
If managed well, refinancing can help improve your financial situation without doing long-term damage to your credit score. As always, it's best to consult with a financial advisor or credit counselor to understand the best options for your unique situation.
By staying informed and monitoring your credit, you can ensure your financial actions, including refinancing, align with your financial goals without negatively impacting your credit health. For more guides and tips on becoming financially independent, check out Vital Card.
Sources
What is a FICO® Score? | Experian
Federal Versus Private Loans | Federal Student Aid
15 Common Personal Loan Terms You Should Know | Experian
What Is a Credit Report & What Is on It? | Equifax
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.