When you refinance a loan, you are basically paying off your current loan by taking out a new one. Refinancing a car or home loan can be a good way to save money if a lower interest rate is available. It may also be a necessity if you need to lower your monthly payment—although paying less each month likely means you'll end up paying more overall because you will accrue more interest over the long term.
Refinancing a loan can affect your credit scores, usually by lowering it, so you should weigh the benefits against the potential hit.
First Steps When Refinancing a Loan
Whether you are refinancing a mortgage or a car loan, be sure to begin the process by checking your credit reports and scores from each of the three credit bureaus to make sure they are free of errors and discrepancies. Access your Experian credit report for free here on Experian.com. You can also visit annualcreditreport.com to access free reports every 12 months from each of the credit bureaus, Experian, Equifax and TransUnion.
Refinancing a Mortgage vs. a Car Loan
A mortgage refinance can save you significant money in the long term, especially if interest rates have come down since you first got your mortgage. If your credit history has significantly improved from the time you first applied for your mortgage, you may also qualify for much better rates during the refinance.
Refinancing an auto loan might be a good way to save money, but it's also generally more difficult to get because cars depreciate so quickly in value. If you owe more money than your vehicle is worth, it's probably not a good idea to consider refinancing. However, if your credit scores have improved or you can get a significantly lower interest rate, it may be worth it.
Lenders Will Check Your Credit, Causing It to Dip
When you are refinancing a loan, you are likely to shop around for the best value. You should know, however, that every time you apply for a new loan, the lender will check your credit reports and scores. That means there will be a hard inquiry on your credit reports, which can cause your scores to take a small, temporary hit.
These inquiries will stay on your credit reports for two years, but in most credit scoring models, they are only really counted during the first year they are on the report. The money you save through refinancing, especially on a mortgage, usually outweighs the negative effects of a small credit score dip. And as you pay off your new loan over time, your credit scores will likely improve as the result of a strong payment history.
How Rate Shopping Affects Your Credit Scores
Multiple loan inquiries for the same type of loan in a short window of time (ranging between 14 to 45 days) are typically treated as a single inquiry by most credit scoring models. If you spend several months on the process, however, your scores will take multiple hits. That could make it difficult to qualify for the best rates.
Your Old Accounts Will Be Closed
When you refinance a loan, you are closing out an old loan account and replacing it with a new one. This can affect your credit scores because most scoring models take into account the age of the credit accounts on your credit reports. The longer your credit history, the better.
When you close out a loan that you've had for a while, that could hurt your credit scores because you are shortening the average length of time the loans are on your credit reports. However, some scoring models will still consider your payment history on the closed account, which means your scores will not be affected as much.
Missed Mortgage Payments When Refinancing
Because refinancing a home loan can be a lengthy process, it's important to stay on top of the payments for your old loan. Sometimes borrowers miss a mortgage payment during refinancing, and that can cause your credit scores to fall.
Here's how it might happen: When you get approved for a new mortgage to pay off the current one, you may be told you can "skip" the payment on your current loan because the new loan will cover it. While that's true, the new lender's payment could arrive after the date your old payment was due, making it a late payment. To make sure that this doesn't happen, talk to your loan officer to ensure that the transition payment is made on time.
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.