Are you looking for a way to lower your monthly payments and free up more cash you can stow in your savings account, put into a retirement plan or simply use for living expenses? One way to do this is by refinancing any outstanding loans to a new loan with a lower interest rate and lower monthly payments. Before you explore this option, however, it's important to know that refinancing a loan may have an effect on your credit by temporarily lowering your credit score. Here's what to consider when deciding whether or not to refinance a loan.
How Refinancing Can Lower Your Credit Score
Refinancing can lower your credit score in a couple different ways:
- Credit check: When you apply to refinance a loan, lenders will check your credit score and credit history. This is what's known as a hard inquiry on your credit report—and it can temporarily cause your credit score to drop slightly. However, 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.
- Multiple loan applications: To find the best loan terms when refinancing, you'll probably apply to several different lenders to see which one gives you the lowest interest rate. To keep all of these hard inquiries from hurting your credit score, make sure to submit all your loan applications within a short period. Most credit scoring models treat loan inquiries between a 14-day to 45-day period as one inquiry, minimizing the hit to your credit score. Applying for different loans over a period of several months, on the other hand, could have a lasting negative effect on your credit score.
- Closing an account: The loan you are refinancing will be closed, which can also lower your credit score because you are closing a long-standing credit account. However, some credit scoring models will take into account your payment history on the closed loan. As long as the closed account was closed in good standing, this lessens the hit to your credit score. In addition, as you pay down the new loan, your credit score should improve again.
Refinancing Your Mortgage
If you are refinancing a mortgage, make sure that you continue making payments on your old loan. Once your new mortgage loan is approved, it's easy to get confused as to what payments are due, when and to which lender.
The new lender may tell you that you can skip your last payment on the old loan because the new loan will pay it off. However, if the new lender's loan payoff arrives after your last payment on the old mortgage is due, you could get dinged for a late payment, negatively affecting your credit score. Since it's your credit score that's on the line, it's your responsibility to ensure that the final payment is made on time.
Refinancing Your Auto Loan
Refinancing a car loan may be worthwhile if interest rates have dropped or your credit score has improved since you took out the loan. You might also want to refinance your car loan if you simply need to reduce your monthly expenses.
Refinancing for a longer-term auto loan will lower your monthly payments, but depending on how long you stretch out the loan, it could increase the total amount you pay for the car. Make sure that the new interest rate is low enough that it doesn't drastically increase your total cost. To refinance, you'll need a car that has held its value; generally, the car must be worth more than what you still owe on it for lenders to consider refinancing.
Refinancing a Personal Loan
You might consider refinancing a personal loan if your credit score has improved or interest rates have dropped since you first got the loan. You might also want to refinance to consolidate several personal loans into one, larger personal loan.
Like any other type of refinancing, refinancing a personal loan will cause a temporary dip in your credit scores due to the hard inquiries on your credit report. However, if you're using a new personal loan to refinance more than one existing personal loan, you'll have fewer open accounts with outstanding balances, which can help boost your credit score.
What to Do After Refinancing
Whenever you refinance a loan, your credit score will decline temporarily, not only because of the hard inquiry on your credit report, but also because you are taking on a new loan and haven't yet proven your ability to repay it. Be sure to make your payments on time, and after a few months, your credit score should go back to where it was. In fact, it may even improve as you show that you're able to handle the new loan. To see how refinancing and your new loan payments are affecting your credit score, you can get a free credit score to check.
Refinancing a mortgage, auto loan, personal loan or other loan can help lower your interest rates, reduce your monthly payment and give you more wiggle room in your budget. But because refinancing can negatively affect your credit score, it's important to carefully weigh the benefits versus the costs before you start shopping for a new loan.