If you’re thinking of refinancing your mortgage, auto loan or your student loans, you may be wondering if it will affect your credit. The short answer is yes. But the good news is that the impact won’t be major or last too long.
Want to refinance and keep your credit in good shape? Read on to discover how refinancing can affect your credit and how you can minimize the impact.
What Is Refinancing and How Does It Affect Your Credit?
Refinancing essentially means taking out a new loan or mortgage and using the proceeds from the refinancing to pay off your current loan.
Refinancing can lead to a slight short-term drop in your credit score. But knowing how credit works can help you minimize the drop in your credit score and reap great refinancing benefits. Let’s look at some of the benefits.
- Pay a lower interest rate: If interest rates were higher or your credit has improved since you first took out your loan, refinancing may let you qualify for a lower interest rate. This can lower your monthly payment or reduce the amount you pay in interest in the long run.
- Shorten the repayment period: Want to pay off your loans faster? Refinancing to a shorter loan period can help you get out of debt sooner. If you’re paying off your current balance in less time, you may have a higher monthly payment, but lenders tend to offer lower interest rates for shorter loan terms. So that can help you pay less in interest in the long run.
- Extend the repayment period: Refinancing to extend your loan for a longer term can help lower your monthly payments, giving you more cash flow each month and the flexibility of a lower minimum mortgage payment. You can always pay down extra principal in months where you have more cash, but your required payment will be lower for the months when you only want to pay the minimum.
What Are Some Reasons to Refinance
Of course, different types of loans come with different reasons to refinance. We’ve gathered some financial information to help guide you if you’re considering refinancing.
Refinancing a mortgage can be especially beneficial because mortgage loans are long-term investments with 8– to 30-year terms. On average, refinancing to a lower interest rate and/or shortening your loan term can save you tens of thousands of dollars over the life of your loan.
Also, if you originally bought your home with a down payment of less than 20% or you used a Federal Housing Administration (FHA) loan, you’re probably paying for mortgage insurance. If you’ve lowered the amount you owe and your home has gained enough value, refinancing can help you lower or possibly eliminate your mortgage insurance payments.
FYI: You’ll need to pay for closing costs as you did with your mortgage when you bought your home, which can cost between 3% – 6% of the total mortgage.
Student loan refinancing
Federal student loans tend to offer competitive interest rates and other potential benefits like loan forgiveness and income-based repayment plans. Unfortunately, federal student loans only offer loan consolidation, but don’t offer a refinancing option.
For that reason, you may want to refinance your student loans into a single private student loan to take advantage of lower interest rates and an improved credit score or to consolidate multiple loan payments into a single payment.
Auto loan refinancing
If you have an auto loan with a higher interest rate, refinancing can save you money on your monthly payments, or allow you to spread out your payments to make them more manageable.
Debt consolidation loan
If you have credit card debt and are interested in debt consolidation, you could use a personal loan to get a lower interest rate and take advantage of fixed monthly payments. Just make sure you aren’t adding more credit card debt once you’ve started paying off your loan.
When the amount you owe for a loan is more than the value of the asset itself.
Why Refinancing Can Lower Your Credit Score
Because of the way that credit reporting agencies determine your credit score, refinancing can lower your credit score. As we’ve pointed out, this is usually minimal and temporary. That said, here are some factors that deserve a little extra attention if you plan to refinance.
When you start shopping for a new loan, lenders will perform a hard inquiry or hard pull on your credit. This means they are “officially” checking your credit. The credit reporting agencies will record this activity and take it as a sign that you’re serious about taking out a new loan.
When this happens, your credit score may drop by 5 points for each hard inquiry. The good news is that credit agencies will count multiple credit checks as one credit check as long as they’re for the same type of loan and happen within 14 days. So, four mortgage-related hard credit pulls in 2 weeks will only drop your credit score by 5 points – not 20 points.
Closing an old account or adding a new credit account
Credit bureaus look at the length of time you’ve had a line of credit. The longer you’ve had it, the better. If you’re using a new line of credit and closing an old line of credit at the same time, that can also impact your credit score.
Increased credit utilization
Lenders are also going to look at how much of your available credit you’re using. If you are taking out a new loan while still holding your old loan, you could see a short-term drop in your credit score because it looks like you’re taking out two loans at once. After your original loan is paid off, and you start making payments on your new loan, your score should balance out quickly.
What You Can Do To Cushion the Impact On Your Score
The good news is you have some control over how much refinancing will affect your credit.
Check your credit report before and after
It’s a good idea to check your credit report before you refinance any kind of loan, so take advantage of your free annual credit report. It’ll give you an in-depth review of your credit history. Look for any credit issues like unfamiliar lines of credit or charges you don’t recognize. It may be a sign that someone is using your credit fraudulently.
Keep up your good credit habits
Once you’ve gotten your new loan, make sure you’re paying all your bills on time, especially the monthly payment for your new loan. One tip, setting up an automatic payment can help ensure that you don’t forget any payments.
Space out multiple refinances
If there are hard pulls for different types of loans (a mortgage refinance and an auto loan refinance) during the same time, they will count as separate pulls for each loan type. And each pull will lower your credit score by 5 points.
Focus on one refinance at a time and allow at least 2 – 4 months or at least 1 – 2 payments to clear before moving on to your next refinance.
If you can, get multiple offers within 14 days of each other. You can compare them to see which one offers you the best mix of low interest rates and affordable monthly payments, helping your credit in the long run.
When Should I Consider Refinancing?
Timing your refinance is also important. Ideally, you want to do it at a time when both the economy and your finances are properly aligned. Ideally, try to refinance when:
- Interest rates are low: If available interest rates are lower than when you first took out the loan, it means that lenders are usually able to offer lower interest rates if you have good credit. When refinancing, you usually want to try to lower your interest rate by at least .75% or better. Otherwise, you may wind up paying more upfront with not a lot of gain. However, this varies by loan type and loan amount. Always compare what you’ll pay for a refinance against how much you’ll save.
- You have a solid employment history: Lenders want to know that you’ll be able to pay back your loan. Two years or more of consistent employment is preferred and the fewer job changes, the better. Also, try to avoid changing jobs while applying for a new loan.
- Your credit score has improved: Track your credit score over time. If you’re able to improve your credit score, you may be able to get a better deal in interest and loan terms when you refinance. While some fluctuations are normal, a steady increase in your score over time shows that your credit has improved. For example, if your credit was around 620 – 640 when you bought your home and it’s now over 680, it may be a sign that your credit has improved.
- Your credit utilization ratio is 30% or lower: Your credit utilization ratio is the amount you owe on credit cards and other loans, divided by the available credit that you have. For example, if you have two credit cards, each with a $10,000 limit, a $3,000 balance on one card and a $2,500 balance on the other, your credit utilization ratio would be 27.5%.
- Your debt-to-income (DTI) ratio is 36% or lower: Your DTI is the percentage of your gross monthly income required to pay your rent or mortgage and meet fixed monthly obligations like credit card bills and other loan payments. Not sure what your DTI is? You can use our DTI calculator to figure it out.
Is Refinancing a Good Idea?
Refinancing won’t hurt your credit, though it may cause a small short-term dip. But when you consider the potential benefits of refinancing such as lower interest rates, lower monthly payments or getting out of debt sooner, a well-planned refinance more than makes up for a short-term dip in your credit score.