Refinancing a loan can be a good way to access a lower interest rate or reduce your monthly payment.
However, refinancing can have a negative impact on your credit score and isn’t a decision to be taken lightly. It’s important to understand how refinancing works and what the consequences are when considering it as an option to manage your debt.
Below, we’ll talk about what refinancing means, how it affects your credit score, and when is the right time to refinance a couple of different loans.
Refinancing is when you take out a new loan to pay off another loan, and adjust the terms of the loan agreement.
If you qualify for refinancing, you may be able to take advantage of lower interest rates and reduce your monthly payments by extending the loan term.
Refinancing can be a great option if your credit score has improved since you applied for the original loan or if your financial plans would benefit from consolidation.
It can also be beneficial if you’re struggling to make higher monthly payments, but it may also mean paying more in interest over the course of the loan.
Below you’ll find three main ways refinancing a loan can lower your credit score.
Hard credit checks: When you’re comparing the best refinancing terms, lenders typically decide whether you qualify for credit by running a credit check.
If you’re only reliant on the pre-qualification process, you may only have to undergo a soft credit check that won’t affect your credit score.
However, some lenders require applicants undergo a hard credit check that linger on credit reports for two years and can lower your credit score by five points.
Multiple loan applications appear on your credit report: Each time you refinance with a different lender, the hard credit check will appear on your credit report, and may lead to your score dropping.
You can somewhat avoid this by applying through all of the lenders within a short time period. This is usually a 14-45 day window, but this depends on the scoring model.
Closed accounts appear on your credit report: Refinancing a loan means closing the original account, and this will appear on your credit report.
The impact of closing an account varies depending on how much you’ve owed on the account and for how long.
Generally, the best time to refinance a loan is if your credit score has significantly increased or if interest rates have dropped from when you first borrowed.
However, even with a good credit score the best time to refinance a loan will vary depending on the type of loan.
Refinancing a mortgage: The best time to refinance a mortgage is when you can save money from doing so, or if it lowers your monthly payment.
Depending on the market conditions, refinancing can help you save interest over the long term, but it can also help to close a Federal Housing Administration (FHA) loan with high mortgage insurance premiums.
Refinancing your mortgage is also a great option when you need to draw from your home’s equity.
However, refinancing a mortgage comes with closing costs, such as an origination fee, appraisal costs, title insurance and credit reporting fees. These costs can increase the total loan amount by 2% and 6%.
Furthermore, refinancing a mortgage also involves extending payments over a long period of time. This means that interest will accrue for longer, even as the amount you pay every month decreases.
If you would like to refinance your mortgage, make sure to use a mortgage refinance calculator to find out what the break-even point would be.
Refinancing an auto loan: This may be an option if you’re now able to access lower interest rates than when you originally financed the vehicle.
This may apply to you if interest rates have fallen or if the vehicle was financed through a dealership that didn’t offer the most competitive rates.
If your credit score has increased since you bought the car, and you can show that you have made punctual, consistent payments, you may also qualify for a better rate than you did originally.
As well as accessing a better interest rate, refinancing an auto loan can lower your monthly payments by spreading out repayment over a longer period of time.
But like refinancing other types of loans, this can increase the interest you pay over the course of the loan. Your current auto loan may also impose a repayment ability that can make refinancing more costly.
Generally, refinancing an auto loan is the best option if your car is still worth more than the outstanding balance of your current loan. Under these circumstances lenders are more likely to extend refinancing, but this isn’t always the case, especially because vehicles can quickly depreciate in value.
Refinancing a personal loan: Like other types of loans, the best time to refinance a personal loan is if your credit score has improved since the original loan was taken out and you qualify for a better interest rate.
Refinancing may also be a good option if you need to lower your monthly payments or you want to consolidate a number of personal loans into one lower interest loan.
A few scenarios where refinancing a personal loan is recommended are if your credit score has improved since the loan was originally taken out, you have a variable annual percentage rate (APR) and want to refinance into a fixed rate loan, your income has been reduced and you need to lower your monthly payments, you want to avoid an upcoming inflated payment, you’re able to pay the lender’s application and original fees, or you want to pay off your loan sooner by refinancing into a loan with a shorter term.
If you want to refinance a personal loan or any other debt, it’s important you build your credit in order to qualify for a more competitive rate.
