How Refinancing Affects Your Credit
Refinancing your mortgage presents a great opportunity to save money by lowering your interest rate and monthly payments. If interest rates have fallen since you originally obtained your mortgage, or if you’ve diligently worked on repairing your credit and improving your credit score, you might benefit from exploring your options for refinancing.
Before you do, it’s important to consider whether refinancing could potentially hurt your credit. The way refinancing affects you depends on a few different factors. Let’s take a look at what refinancing is and how it can impact your credit.
What is refinancing?
The process of refinancing pays off your existing loan with a new one. People commonly refinance to take advantage of better interest rates that will lower their monthly payments and save them money throughout the life of the loan. Refinancing is most commonly associated with mortgages, but you can refinance any number of loans, including car loans, student loans, and personal loans.
When applying for a new loan, the creditor checks your credit report with what’s called a “hard inquiry.” Hard inquiries lower your credit score by a few points. If you shop around for rates and creditors make multiple hard inquiries, this could have a negative impact on your credit score—unless you’re smart about it.
FICO treats multiple loan inquiries of the same category (auto, mortgage, student, etc.) in a short period of time as a single inquiry. If you shop around for rates but find the right loan within a specified period of time, your score will only be affected by a single inquiry. Keep in mind, however, that this applies to rate shopping rather than applying for multiple new credit lines, such as credit cards.
Here’s where it gets a little complicated. The specified period of time varies depending on which version of the FICO formula the creditor uses. In the latest version of the formula, borrowers have 45 days to find the best rate. However, the period is only 14 days for older versions.
Refinancing also results in closing an old loan account and opening a new one. This means you’ll lose your payment history for the previous account in some credit reports. Since payment history makes up 35 percent of your FICO score, this could have a negative impact. Other reports and score models will continue to include your payment history for the closed account, which will result in negligible impact on your credit.
Should you refinance?
It always pays to consider how a financial decision will affect your credit score. In the case of refinancing, the benefits of lower interest rates and lower monthly payments far outweigh the negligible negative effects the process will have on your credit. The minor impact of hard inquiries on your credit report will fade over time as you build payment history with your new, refinanced loan, and benefit from the extra money in your pocket.