By Karen Lynch | American Express Credit Intel Freelance Contributor
5 Min Read | June 14, 2021 in Credit Score
People tend to refinance loans to get lower interest rates, decrease their monthly payments, and sometimes raise money to pay off other debt. In the short term, refinancing usually lowers credit scores slightly, and then they bounce back. But in some cases, refinancing can help you increase your credit score in the long term. This is particularly true if your goal in refinancing is to make your personal finances more manageable.
When you apply to refinance a home loan, auto loan, or student loan – that is, to replace your existing loan with one that has more favorable terms – you usually trigger what’s called a “hard inquiry” into your credit history. For most people, these credit checks will take less than five points off their credit scores, according to credit bureaus and their scoring model providers, Fair Isaac (FICO) and VantageScore Solutions. That’s relatively minor since the full range for FICO scores is 300 to 850.1
Why the drop? As you apply for a new loan, a lot is going on in the background. Lenders report your application to the credit bureaus. FICO’s and VantageScore’s systems then read your application as an indication that you’re acquiring new debt, a factor that accounts for about 10% of your credit score. But they haven’t yet received information from a lender about an actual loan. So these risk-averse systems ding your credit score until you take out a loan, it’s reported to them, and they can begin tracking your loan payments. In a few months – assuming your loan payments are consistently on time – you should see your score rebound.
There are other factors to consider that could make a bigger difference in your credit score.
Rate shopping: If you shop around for rates from different lenders and trigger several hard inquiries, FICO’s or VantageScore’s systems could misread this to mean you’re in financial distress. The result could lower your credit score by more than the average single digits. In some cases, though, the systems don’t factor in multiple credit checks – for instance, if you do all your rate shopping within a shopping period of 14 to 45 days. Since the size of that window varies depending on which lender is pulling your credit score, you may want to consider staying within two weeks to play it safe. And there’s another window to keep in mind: If you find a loan within 30 days, FICO might not reflect any of those credit checks in your score.
Credit history: Some people’s scores could dip more than usual due to a hard inquiry if they have a short credit history or only a few accounts. Speaking of history, you might be reassured to know that your old loan usually remains on your credit report for 10 years if it was in good standing. That’s important because the length of your credit history accounts for 15% of your FICO score. For more information, read “How Long Does a Closed Account Stay on a Credit Report?”
Reporting: If you go back to the bank that made you the loan in the first place, there’s something else to watch for. It’s a good idea to ask whether they’ll categorize your loan as “new” or as a loan modification. New loans could cost a few more points on your credit score because they could be interpreted as new debt.2
Timing: And just so you know, hard inquiries could stay on your credit report for two years, though FICO credit scores only factor in inquiries from the previous 12 months.
In the longer term, refinancing can improve your credit score. It depends on the type of refinancing and on how you manage your newly refinanced loan.
Cash-out refinancing: Some people do a cash-out refinancing of their mortgages to raise money for consolidating other debts and paying them off. Cash-out refinancing involves replacing your existing mortgage with a new one whose amount is higher than what you currently owe, which is how you come away with money in hand. Paying off credit card debt with this money would lower your credit utilization rate, which makes up 30% of your credit score. That’s because your credit utilization rate is only based on revolving credit, like credit cards and lines of credit, and not on installment credit, such as mortgages. Another benefit of refinancing could be greater ease of managing your debt and making monthly payments on time since you’d be paying in predictable installments, versus credit card bills whose balances can vary from month to month.
Managing personal finances: The goal of refinancing is often to make personal finances more manageable. If refinancing makes your monthly payments more affordable, for example, you have a greater chance of paying in full, on time, every month. Since payment history makes up 35% of your credit score, this can make refinancing a path to a higher score.
Knowing whether refinancing will have a positive or negative affect on your credit score is not like splitting atoms, but it’s not straightforward either. Arm yourself with basic information before you get started, ask your lenders questions along the way, and stay on top of your credit score before, during, and after your refinancing.