How Does Refinancing Affect My Credit Score?

Managing your debt can be tough. You want to use debt wisely, getting low interest rates, taking on the right amount of debt for your income level, and building your credit score -- but that's easier said than done.

Many borrowers turn to refinancing when they're struggling with debt repayment. But there are many factors to consider when refinancing a loan. Make sure you understand the potential effects of refinancing before you act.

Why refinance?

When you refinance a loan, you're essentially taking out a new loan to pay off an existing loan. The goal is to make your debt more manageable by applying new repayment terms. Think of refinancing as hitting the restart button on a loan.

There are many types of loans that can be refinanced for lower interest rates, longer repayment terms, or lower monthly payments. These include:

• Mortgages
• Car loans
• Credit card accounts
• Student loans
• Personal loans
• Small business loans

The ultimate goals of refinancing are dependent on the type of loan you're replacing. For example, refinancing a mortgage might result in a higher interest rate but a lower monthly payment. If you're looking for lower monthly payments, the higher interest rate might be worth it. However, you'll end up paying more over the life of your loan.

Before you decide to refinance a loan, make sure you understand how it could affect other aspects of your finances.

Pros of refinancing

Some common benefits of refinancing include:

• Securing a lower interest rate
• Lowering monthly payments
• Saving money on interest with shorter repayment terms
• Consolidating multiple loans
• Changing your loan type (i.e., variable-rate loan to fixed-rate loan)

But not all of these benefits will apply in every case, and it's important to balance them with the cons.

Cons of refinancing

Some of the potential downsides of refinancing include:

• Increasing the total amount paid with longer repayment periods
• Early repayment fees and penalties associated with larger loans
• Higher interest rates
• Losing flexible repayment options and other benefits (particularly when switching from federal to private student loans)
• Lowering your credit score

If you're looking to refinance one or more loans, speak to a financial advisor and stay informed about exactly what refinancing will do to your financial wellness, especially your credit score.

What about your credit score?

Before you refinance, check your credit score to make sure you're likely to get good terms. The higher your credit score, the lower your interest rate is likely to be -- and the less you'll pay over the course of the loan.

In most cases, refinancing a loan will ding your credit score. If you approach multiple lenders to see who offers the best rates, each lender will run a credit check known as a "hard inquiry." Any time there's a hard inquiry of your credit, your score will take a minor hit. Thankfully, most credit scoring models will consider multiple hard inquiries within the space of a month as a single inquiry, so it's smart to shop around for the best terms in the shortest amount of time possible.

Your credit score is also lowered when you close out your original loan through refinancing. Though this might sound a little counterintuitive, it makes sense when you think about the fact that creditors calculate your score based in part on your loan payment history and the average age of your accounts. If you cut a loan short, you erase the opportunity to establish a solid repayment history.

How long will your credit score take to recover?

When your credit score goes down after refinancing, it can be a little daunting. Luckily, the hits to your credit score are only temporary if you keep up with your payments.

Lenders' hard inquiries will usually take one to two years to stop affecting your credit score. The good news is that during this time, you'll likely erase their effects by making payments and strengthening your payment history.

When you close your original loan out by refinancing, you also lower your credit score. Though the new line of credit will take a while to build history, some credit scoring models will still take your old repayment history into account. This is good news for your credit score in the short term. 

In the long run, it will take time to establish a payment history and raise your credit score once again. Every borrower's situation will look different, but if you have other loans with significant payment history, your credit score will be in better shape and recover more quickly.

Other repayment options

If you're not willing to lower your credit score to refinance a loan, there are other options available to you. 

The simplest option for mortgages is recasting your loan. With the help of a professional, you can examine your finances to discover the ideal monthly payment that will satisfy your loan principal and cut down on your total interest payments. This works when you need to pay off a loan faster.

If you're looking to free up funds, you can borrow against the equity of a loan such as your mortgage. However, this creates its own set of pros and cons.

While refinancing a loan will have a temporary effect on your credit score, it might be worth it for your particular situation. Just make sure you make an informed decision that's right for your current and future self.

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