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Refinancing a personal loan could lower your monthly payments, save you money on interest and make it easier to manage your bills. Sounds good so far, but there's also a downside. Refinancing a personal loan involves taking out a new loan to pay off your current loan (or loans), which might hurt your credit scores.
Generally, if you make your loan payments on time, this isn't a long-term concern and your scores will rise again. But it's something to be aware of as you're considering refinancing a personal loan.
How Refinancing Impacts Your Credit Score
Here's a look at the three main steps in the loan refinancing process and how each one can affect your credit scores.
1. Shopping for a New Loan
Each loan application you submit could result in a hard inquiry, a record of when a lender checks your credit report before making a lending decision. Hard inquiries stay on credit reports for two years and may affect credit scores for the first 12 months.
When they impact your credit scores, hard inquiries tend to lead to a small drop. The drop is often offset within a few months as long as you're making on-time payments on your new account and no other negative information gets added to your credit report.
Multiple hard inquiries during a short period can increase the drop in scores. However, credit scoring models also know that rate shopping is a financially savvy practice.
With this in mind, some credit scoring models don't consider inquiries from the last 30 days, meaning your applications from last week won't impact your application this week. Scoring models may also count all the hard inquiries that occurred in a 14- to 45-day window as a single inquiry when calculating your credit scores.
2. Opening Your New Account
Opening the new loan you'll use to refinance your personal loans can impact your credit scores in several ways:
- It may shorten your average age of accounts, which could hurt your credit scores.
- If you're taking out one new loan to refinance multiple personal loans, that might increase your scores because you'll have fewer open accounts with balances.
- As you start repaying your new loan, your on-time payments can help you build a positive credit history, which can increase your scores.
3. Paying Off Your Old Loans
The loans you refinanced will be closed once they're paid off. The old accounts will remain on your credit reports for up to 10 years, and any negative or positive information associated with the account, such as late or on-time payments, could still impact your credit scores during that time.
Your scores may be hurt when your closed accounts drop off your credit reports, as that could decrease the length of your credit history and average age of accounts.
When to Consider Refinancing a Personal Loan
Refinancing a personal loan can help you:
- Save money by lowering your interest rate.
- Improve your cash flow by lowering your monthly payment.
- Make managing your debt easier by combining multiple loans.
In some cases, you may be able to accomplish two, or even all three, of these goals at once. However, if you're paying less each month, you might wind up paying more interest overall unless you qualify for a significantly lower interest rate.
You may want to look into refinancing if your credit or income has improved since you first took out your personal loan. Even if your creditworthiness has stayed about the same, if interest rates have generally gone down, that might also be a cue to start shopping.
As you're comparing loan offers, a debt refinancing or loan consolidation calculator can help you determine your overall cost or savings.
How to Refinance a Loan
These five steps are a summary of the refinancing process, although it can vary depending on the lender and type of loan you're taking out.
1. Check Your Credit
Checking your credit scores can give you an idea of which lenders or loan types might be a good fit for you right now. If you have poor credit, you may want to work on improving your credit before refinancing your personal loan.
2. Shop Lenders and Compare Loan Offers
Whether you're looking for the lowest possible interest rate or lower monthly payments, you may want to submit multiple applications to see which lender offers you the best deal.
Start by making a list of the lenders that offer loans that meet your criteria. Consider the minimum and maximum loan amounts, terms and interest rates that each lender advertises. If you can find information about their typical credit score requirements, that can help you narrow the list.
Experian's CreditMatch™ service can also match you with multiple lenders and loan offers based on your credit profile.
3. Apply For and Accept a Loan
Once you've identified good potential lenders, submit multiple applications starting with the lender you think is the best fit. To limit the impact on your credit scores, try to submit all your applications within 14 days.
You can then compare your official loan offers from each lender before accepting the best one.
4. Pay Off Your Old Loans
Some lenders may be able to send the money you're borrowing directly to your current creditors to pay off your loans. Otherwise, the lender might send you the funds, which you can then use to pay off your personal loans.
5. Confirm Your Old Loans Are Paid Off
Don't forget about your old loans until you've confirmed that the accounts have a zero balance and are closed. You don't want to wind up accidentally missing a payment due to poor timing.
Is Refinancing a Personal Loan Worth a Drop in Credit Scores?
Overall, refinancing personal loans may lead to a minor drop in your credit scores due to the hard inquiries from the applications and opening of a new credit account. Over time, your scores may recover and then increase if you continually make on-time payments on your new loan. Generally, the small drop is worth it if refinancing can save you money or make managing your loan payments easier.
Want to instantly increase your credit score? Experian Boost™ helps by giving you credit for the utility and mobile phone bills you're already paying. Until now, those payments did not positively impact your score.
This service is completely free and can boost your credit score fast by using your own positive payment history. It can also help those with poor or limited credit situations. Other services such as credit repair may cost you up to thousands and only help remove inaccuracies from your credit report.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.