How Does Refinancing Affect My Credit Score?

Refinancing is one way to get a better deal on a loan or credit account, such as a mortgage, personal loan, or auto loan. Although it has personal finance benefits, refinancing affects your credit score, usually causing a small, temporary drop. To help you understand the implications of refinancing a loan, here's a full guide answering the question, "How does refinancing affect a credit score?"

How refinancing affects your credit score

There are two ways refinancing affects your credit score:

• When you check rates with a lender, the lender reviews your credit history. This puts what is called a hard inquiry on your credit report. Each hard credit inquiry decreases your credit score by a small amount.
• With refinancing, the previous loan is technically closed and replaced by a new loan. Since older accounts are better for your credit (as they give you a longer credit history), having an older loan replaced by a newer loan can ding your credit score.

You can minimize how much your credit score drops by rate shopping in the shortest amount of time you can. Here's why: Multiple hard inquiries can add up and lower your credit score more. However, most credit scoring systems group hard inquiries together if they're during the same time period -- anywhere from 14 to 45 days.

The time period varies because different credit scoring systems have their own guidelines. Newer systems give you up to 45 days, but older ones may only give you 14. Play it safe when you're rate shopping by submitting all your applications within 14 days of each other.

The type of loan you refinance can make a difference in how it impacts your credit score, so let's look at two of the most common types.

Mortgage refinancing

When you refinance a mortgage, it's considered getting an entirely new mortgage. As a result, it can impact your credit. Let's say you have a mortgage for $250,000 that's halfway paid off. Having 50% of the original loan amount repaid is good for your credit.

You then get a mortgage refinance, resulting in a new mortgage with a balance of $125,000. That can lower your credit score, because you haven't paid off any of your new mortgage. Even though you owe the same amount, it looks as if you aren't making progress on paying off your debt. For credit scoring, a loan for $250,000 that you paid down to $125,000 is better than a loan for $125,000 that hasn't been paid down at all. This boils down to the positive impact that on-time payments have on your credit score -- your new mortgage has had no on-time payments yet.

Even with the possibility of taking a credit score hit, the advantages of refinancing your mortgage can more than make up for it. A lower interest rate could save you many thousands of dollars over the life of your mortgage. Or, if you opt for lower monthly payments, you'll save on one of your biggest monthly bills and can free up money for other expenses and make budgeting easier.

If you'd rather not lower your credit score to refinance a mortgage, an alternative is mortgage loan recasting. With this option, you make a lump-sum payment. Your original loan term and mortgage interest rate stay the same, but you pay less interest overall because you've paid down more of the principal. You also lower your monthly payments in the process. Most mortgage lenders offer recasting on conventional mortgage loans.

Personal loan refinancing

When you refinance a personal loan, it will affect your credit score much the same way as refinancing a mortgage. For example, your credit score could go down a bit when lenders review your credit report with a hard inquiry. The new loan can also decrease your score because older accounts are considered better in credit scoring systems.

There is also a way loan refinancing could boost your credit score. If you're refinancing multiple personal loans, you'll end up with fewer loans to pay off. Having fewer personal loans is better for your credit.

The benefits of refinancing

Although refinancing can ding your credit score, there are potential benefits that make it worthwhile.

By refinancing a loan, you're effectively replacing that loan with a new one. You could get better loan terms, especially if you've raised your credit score since getting the old loan. How you benefit depends on what your goals are. Here are a few reasons you might want to refinance your loan.

• Secure a lower interest rate
• Reduce your monthly payment
• Save money on interest with a shorter repayment term
• Consolidate multiple loans
• Change your loan type (for example, going from a variable-rate loan to a fixed-rate loan)

Of course, there can be downsides to refinancing as well. If you reduce your monthly payments, it will likely extend the length of your loan repayment and you'll pay more interest in total. If you get a shorter repayment term, your monthly payments could increase, which could in turn affect your financial plans going forward.

It's important to consider any potential drawbacks before you refinance. You should also check your credit score first. If it has gone up since you got the loan initially, you're more likely to get good terms. Note that most lenders look at your FICO® Score, so that's the one you should check.

Rebuilding your credit score after refinancing

Your credit score will probably drop when you refinance a loan, but remember that this is temporary if you follow the right steps. Here's how to rebuild your credit as quickly as possible.

• Continue paying your old loan until the refinance process is complete. Until that loan is closed, you still need to make payments. If you don't and the lender reports a missed payment to the credit bureaus, it will significantly damage your credit.
• Make all your new loan payments on time. This helps you establish a good payment history on the new loan and increase your credit score.
• Avoid credit applications for at least a year after you refinance. You don't need more hard inquiries lowering your credit score.

It's good to be aware of how refinancing affects your credit score before you do it. Most of all, carefully consider the benefits of refinancing so you can decide if it's the best move for your situation.