Borrowers have several reasons to refinance their loans. Some people refinance to capitalize on reducing their monthly payments. A lower interest rate or extending the loan to spread out the money can create more room in the budget for other expenses. A refinance can also help you get extra cash for an emergency or pay off your loan sooner. The loan refinance offers considerable flexibility but will impact your credit score. We will discuss how a refinance and credit score correlate.
How does refinancing affect credit?
Refinancing your loan will result in a hard inquiry. The lender will review your credit report and other financial details to ensure you can afford the new loan. This process also impacts your assigned interest rate, but it will decrease your credit score by a few points. While you can recover from a hard credit inquiry, the refinance’s remaining impact on your credit depends on how effectively you can manage debt payments.
Refinancing a mortgage
Refinancing a mortgage replaces your old loan with a new loan. This process results in a hard credit inquiry, but you also start with a fresh loan. You will also lose the advantage of an older loan. As you make payments, you will regain the credit age advantage, and your new mortgage will begin to contribute to your credit score positively.
Refinancing an auto loan
An auto loan refinance has the same impact as a mortgage refinance. A hard inquiry and removing an older financial obligation from your credit will reduce your score in the short term. Some people use a refinance to avoid making late payments, which has a far worse impact on your score than a loan refinance.
Refinancing a personal loan
A personal loan refinance has the same characteristics as refinancing a mortgage or auto loan. A refinance for any loan impacts your credit score via the same scenarios. The hard inquiry and removing the old loan will hurt your credit in the short term, but the recovery is very doable as you make payments towards the new loan.
How refinancing can help your credit score
Refinancing a loan can improve your credit score over time. A refinance done properly can offer these advantages.
If you make on-time payments
On-time payments are the best way to improve your credit score. Credit bureaus give you a score that assesses how effectively you can manage debt. Payment history is the best indicator of debt management skills and makes up 35% of your score. Refinancing your loan can result in lower monthly payments and make financial obligations feel more doable.
Lower credit utilization rate
Credit utilization is another vital credit scoring category that composes 30% of your score. Every borrower has a credit limit. Using a lower percentage of that credit limit will improve your score. Lowering your monthly loan payments reduces your credit utilization rate. You also have more proceeds each month to pay off other debts and further reduce your credit utilization rate. A credit utilization rate below 30% will improve your score, while a rate below 10% is optimal.
Boost credit mix
Your credit mix reflects your ability to juggle multiple debts. It makes up 10% of your score, and a refinance can strengthen your credit mix. You can demonstrate greater ease in managing debt and have more room in your budget to add an extra loan if necessary. You should not incur debt solely to boost your credit mix, but a wider range of financial obligations will help your score.
How refinancing can lower your credit score
Refinancing your loan can offer long-term benefits for your credit score. However, you will have immediate disadvantages and can face long-term obstacles if you are not careful.
The hard inquiry will lower your score
Applying for a new loan will result in a hard inquiry. This inquiry will negatively impact your new credit category, which makes up 10% of your score. A hard credit inquiry will only drop your score by a few points. Applying for too many loans can make a more considerable dent, but you should not let a hard inquiry stop you from getting a loan refinanced.
Your credit age weakens
When you replace an old loan with a new loan, your credit age weakens. This category makes up 15% of your credit score. You can recover this dip by paying off the new loan. Each monthly payment increases the new loan’s age, and your credit score will be as good as new.
Refinancing your loan may hurt your payment history
The worst-case scenario is if a refinanced loan negatively impacts your payment history. Some borrowers use a cash-out refinance to cover emergency expenses but end up with higher monthly payments. Shortening your loan’s term will also increase your loan payments. Higher payments can make it difficult for some borrowers to keep up with payments. Borrowers who get too comfortable with the lower monthly payments may find themselves in a similar scenario.
How to make sure refinancing doesn’t hurt your credit
If you need a refinance, you can’t avoid the hard credit inquiry or reduced credit age. A refinance primarily hurts credit scores because borrowers cannot keep up with the monthly payments. Borrowers worried about monthly payments can start by extending their loan terms during a refinance.
You can also monitor your credit and request free reports from the credit bureaus. You can request a free credit report from each bureau every 12 months. Spreading your requests will help you see your report more frequently. You can check the report for any errors and dispute them. You can see your credit score without requesting a credit report.
Being more conscious about how you use your money will also help you successfully navigate a refinance. Spending money on unnecessary items gives you fewer resources to make your monthly loan payments. Keeping these expenses to a minimum will improve your financial health. Some people pay their loans first before spending money on other items. You can also make monthly payments in advance to build a buffer in case an emergency comes up.
Improve Your Financial Health with a Refinance
A loan refinance can put more money in your pocket between a cash-out, lower interest rates, extended loan terms, and other strategies. You can also use a refinance to get out of debt sooner. A loan refinance done correctly can improve your credit score in the long term, as long as you keep up with monthly loan payments.
FAQs
Is refinancing bad for credit?
Refinancing will take your score down a few points in the short term, but it’s easy to recover from that drop. A refinance will only have a significant toll on your credit if you fall behind on payments.
What does credit refinancing mean?
Credit refinancing replaces high interest debt with a new loan that has a lower interest rate.
Will refinancing my home hurt my credit score?
Refinancing your home can reduce your credit score in the short term, but it’s an insignificant drop and easy to recover from. As long as you make on-time payments, you won’t have to worry about a home refinance’s impact on your credit score.
