By Tracy Scott
Do you have a loan payment that is squeezing your monthly budget a bit tighter than you'd planned? When you borrowed the money five years ago, you may have been in a different job, childless or paying less on other household expenses. Refinancing may provide the needed relief for your financial situation. It may also prevent you from needing to make bad money choices such as maxing out your credit card for groceries or opening new lines of credit to pay your bills.
What Does Refinancing Mean?
Refinancing is paying off a current loan by originating a new one. The old debt still exists, but it is now in the form of a new loan, quite often with a lower payment and interest rate. You need good credit to qualify for a refinance. Just as when you applied for the original loan, approval is often based on your ability to repay the loan, your employment history, and your current credit score.
What Is A Credit Score?
In short, your credit score is the culmination of your credit history represented as a mathematical calculation and is often expressed on a scale from 300 to 850. Lenders use it to determine the creditworthiness of borrowers, but income and stable employment are also considered by lenders when granting loan approval.
Your credit score lets the lender gauge how much credit you already have, if you're actively trying to get more credit, and your history of paying back debt. The five main factors that make up your credit score are:
- payment history
- the percentage of your available credit that you're using, otherwise known as credit utilization
- the age of your credit accounts and the length of time since each account was last used
- the mix of active credit types that you have
- the amount of new credit you are applying for
How Refinancing Can Hurt Your Credit Score
Refinancing can negatively impact your credit score in ways that directly correspond to the abovementioned factors, as follows.
Payment history - A refinanced loan has no payment history, but the old loan still appears on the account along with any late or delinquent payments. If there were no late payments on the old loan, it will remain on your credit report for up to ten years. If there were any delinquent payments, it will stay on your report for seven years from the original missed payment. Refinancing doesn't fix a poor payment history.
Amount owed - A refinanced loan is a new loan and 100% of the loan value is owed. Little to no available credit on one loan can lower your score by raising your total credit utilization, even if you have other credit accounts with low balances.
Length of credit history - When you refinance, you are closing the credit account attached to the old loan.The average age of accounts decreases when the old loan is paid off and a new one appears.Closed accounts eventually fall off your credit report, even if the payment history was excellent.
New credit - A refinanced loan is by definition a new loan (credit), which contributes less to your credit score than a longstanding line of credit would.
Credit mix - Depending on the type of refinance, the new loan may reduce the desired credit mix. For example, a home refinance that includes cash back to pay off a student loan would eventually remove student loans from your current credit mix. This is, of course, assuming that you really use the cashout to pay off the student loan.
Why Risk A Refinance?
- A new, lower interest rate can save you thousands of dollars in interest payments, depending on the loan amount
- You can get rid of a lender with horrible customer service
- If you used a co-signer on your original loan, he or she would be released from the original loan obligation since it would be paid in full
This might sound like a no-brainer to people who need relief from high monthly payments, but as we've seen, there is more to consider before refinancing a loan.
What Is A Hard Inquiry and A Soft Inquiry?
Has a family member or friend told you to resist pulling your own credit because it can damage your score? They might be confused about the difference between hard and soft inquiries/pulls when it comes to checking your credit report.
A hard inquiry impacts your credit score and requires your consent. Hard inquiries remain on your credit report for two years. Steve Millstein of Credit Repair Expert says, "Whenever you apply for new loans, including refinancing, creditors will always request a copy of your credit report, which leads to new hard inquiries. Hard inquiries generally lower your credit score by a few points."
Millstein says not worry too much about loan shopping if you do it right. "If you are seriously considering refinancing, then lodge your applications within a fourteen to 45-day period to take advantage of the rate shopping period which (depending on the scoring model) may only count as one hard inquiry when your credit score is calculated."
A soft pull is a credit inquiry that doesn't adversely impact your credit. It often occurs without your knowledge. Remember the credit card pre-approval you received last week? Those are often based on soft pulls. Checking your own credit is recognized by the credit reporting agencies as a soft pull, including looking at your credit score and credit report for free on MoneyTips. Most promotional, consumer disclosure, insurance, and employment inquiries do not count against you.
Ultimately, a credit inquiry may or may not impact your credit score or ability to get new credit. It is dependent upon your credit profile and the credit model of the credit reporting agency.
How to Protect Your Credit Score
Dave Sullivan, Vice President of Marketing at People Driven Credit Union, recommends consumers do four things to minimize the impact of a refinance:
- Don't apply for anything else during the refinance process.
- Evaluate loan options in full before allowing the lender to pull a hard inquiry.
- Reduce the amount owed on other revolving credit accounts.
- Don't pay off any old collections.
For the last point, Sullivan explains, "Under certain scoring models, old collections that are paid get a new reporting date. That makes the collection look like it occurred recently, which could reduce an individual’s credit score, when the collection actually occurred years ago."
You might also consider the following tips to help protect your credit score:
- Ask the prospective lender whether they will perform a hard or soft inquiry. Only consent to a hard pull if they are part of your final selection of lenders.
- Keep your credit utilization below 30%. For example, if your credit limit is $1,000, keep credit usage under $300.
- Keep old and even unused retail accounts open to counteract the possible reduction in the average age of accounts that comes with a refinance.
- Be prepared to make a payment on your current loan during the refinance process. Missing a payment at any time will negatively impact your credit score.
- Since your credit report is the foundation of your credit score, make sure you get any errors corrected as soon as possible. You can check your credit score and read your credit report for free within minutes by joining MoneyTips.
A refinance doesn't change the amount of debt you owe. In some cases, it might increase the amount owed. This may occur if you decide to bundle several loans into the refinance loan, are approved at a higher interest rate than expected, or have extended repayment terms. Keeping hard credit inquiries by potential refinance lenders within a two-week period may help reduce the chances of a refinance hurting your credit.
MoneyTips is happy to help you get free refinance quotes from top lenders.