What Is Refinancing + Does It Hurt Your Credit?
If you’re looking to lower your interest rates, you’ve likely stumbled upon the idea of refinancing a loan. But what does refinancing mean—and will it hurt your credit score?
Generally speaking, refinancing shouldn’t hurt your credit score in the long term. There may be some short-term negative effects due to potential hard inquiries or a shortened credit history due to closed accounts, but these things should be recoverable with the right moves.
In the right situation, refinancing can help you lower monthly payments, consolidate debt and even secure more favorable interest rates. However, it’s important to be aware of the potential negative effects refinancing can have on your credit score as well.
You should understand the costs and benefits of refinancing a loan before jumping in yourself. Keep reading to learn about how refinancing impacts your credit score and if it’s a smart option for you.
Refinancing is a loan payment option that involves taking out a new loan to replace an existing one. If your financial situation has changed since taking out your initial loan, you may be able to score a loan with more beneficial terms.
The most common loan refinancing options include auto loans, student loans, mortgages and personal loans. These loan interest rates can vary based on factors like credit score, financial health, debt and annual income. A general rule of thumb for refinancing loans is that you want to reduce interest rates by two percent, but even one percentage point lower can be enough to refinance.
Take a look at the average loan interest rate to determine where your current loans stand and if refinancing might be a good option for you.
Refinancing and Your Credit Score
When applying to refinance a loan, creditors usually run a hard inquiry that can temporarily lower your credit score. However, it can be easy to recover your credit score in a few months by paying your bills on time and in full.
To minimize the negative impact on your credit score, you should try to bundle any hard inquiries by completing them all within a specified time frame. The two major credit score companies, FICO® and VantageScore®, use rolling-day periods of 45 days and 14 days respectively. By bundling your hard inquiries, they will appear as a single inquiry and result in less damage to your credit score (keep in mind that this doesn’t work for credit card applications, though).
Here are the main ways refinancing a loan can negatively impact your credit score.
- Credit checks: Creditors will run a hard inquiry when you apply to refinance a loan. This can hurt your score, but by paying your new loan off on time and building up your payment history, your credit score can recover from this dip pretty quickly.
- Closing your account: When you close your current loan to refinance a new one, some credit scoring models will still factor in your payment history on the old loan. However, if you paid your old loan on time and closed the loan in good standing, the impact of this on your credit score should be minimal.
- Loan applications: When applying to refinance a loan, you likely contacted several lenders to find the best rate. Be sure to contact the lenders within a narrow time frame (usually between 14 and 45 days) to minimize the damage done to your credit score from these hard inquiries.
Do Closed Accounts Affect My Credit Score?
It’s common practice for credit bureaus to remove closed accounts from your credit history after 10 years, so long as they are in good standing. However, it’s important to note that while VantageScore does not count closed accounts toward your credit score, FICO does.
Closing your account can also negatively impact your credit utilization, which accounts for 30 percent of your overall credit score according to the FICO model. Your credit utilization calculates how much of your available credit you’ve used. Generally, it’s good practice to keep your credit utilization ratio at 30 percent or lower. For example, if your credit limit is $5,000, you’ll want to keep monthly spending on that account to less than $1,500.
The average age of your credit is also negatively impacted by closed accounts. When you own a credit card for a long period, it signals to creditors that you are responsibly managing your finances. Typically, the average age of credit makes up 15 percent of your score—meaning that combined with credit utilization, closing your account can affect nearly half of your credit score.
Is It Smart to Refinance?
It’s essential to understand if and when refinancing a loan is a good option for you. Seeing as the average borrower saved an average of $2,000 in annual interest payments in the first quarter of 2020, it’s clear that refinancing can be a great way to save up cash so long as you’re in the right financial mindset.
Generally, people choose to refinance if they can secure a lower interest rate and do the necessary calculations to determine that it would be prudent financially. If you fit any of the below criteria, it’s worth evaluating whether refinancing a loan is a smart move for you.
- You can secure a lower interest rate: Securing a lower interest rate can come from several factors. One major reason for lower interest rates is changing economic conditions that can bring down the cost of borrowing.
- You improved your credit score: If your credit score has been improving in the past year or so, it could be a good idea to reevaluate and see if you can qualify for a loan with a better rate.
- You need to lower current expenses: Refinancing a loan can help you lower expenses in the short term. However, this could mean that you would end up paying more overall, although it would be spread out over a greater period.
In short, refinancing could be a great tool if you’re struggling to meet your debt obligations. The short-term drop in your score due to a hard inquiry could be worth the payoff.
When Refinancing Isn’t Such a Good Idea
While refinancing a loan can be a great option, it’s important to understand whether it’s right for you. Before applying to refinance your loans, see if you fit any of the below criteria to determine if refinancing is a smart move for you.
- You have federal loans and may lose some income: During COVID-19, the government has put together federal loan relief programs. However, if you refinance loans, you may become ineligible for these programs.
- You are applying for loan forgiveness: For those who are repaying student loans, it’s important to note that if the student loans are refinanced, they lose eligibility for federal loan forgiveness.
- You’ve declared bankruptcy: Although it’s still possible to refinance your loans after declaring bankruptcy, it’s significantly more difficult. It’s common for lenders to require a period of four to 10 years since declaring bankruptcy to lend to you.
It’s best to avoid refinancing unsecured debt with secured debt, according to Rick Orford, Personal Finance Expert and Author of The Financially Independent Millennial. “For example, your mortgage company might offer you the ability to refinance your home or apply for a home equity line of credit to consolidate credit cards, car loans, etc,” Orford told us. If you take this route and end up in a tight spot, your home will be at risk, and you’ll potentially lose even more. Only refinance when you have a plan in place.
Consolidating Your Debt
Consolidating your debt with a cash-out refinance allows you to use your home equity to get a new mortgage with a higher balance, which ultimately gives you more spending money based on the leftover balance of your mortgage—but it’s crucial to be smart and financially secure enough to use a cash-out refinance.
It’s also important to be aware of the risk you are assuming. You could end up putting important debt, like the debt on your house, at risk by backing it with unsecured debt.
When determining whether to refinance your loans or not, it’s important to take into account the pros and cons of refinancing for your situation. Although refinancing can hurt your credit for a few months, if you’re smart about it, you can minimize the impact on your credit score while pursuing lower interest rates and less expensive monthly costs.
If you’re looking to repair your credit, it can be tough to know where to start. From the time you spend understanding your score to figuring out your credit history, credit repair is something you want to get right on the first try—which is why many people are turning to our team for help. Check us out and learn more about the services we offer to help you repair your credit today.
from a Credit Expert