Refinancing a loan can help you save money. You can spend less on your monthly payments and you can even reduce the total amount of interest you’ll pay in some cases. Those reasons alone are enough to convince most people to pull the trigger. But what about your credit score? Does refinancing affect your credit negatively?
A Small, Short-Term Hit
You’ll probably see a minor impact on your credit scores when you refinance. That makes sense if you understand how credit scores work: you’ve applied for a loan, which usually dings your credit slightly. We’ll get into some details below, but a more important question is whether or not it matters.
Refinancing might substantially improve your financial situation. If it means your score goes down temporarily, should you not refinance? The whole point of having good credit is to take advantage of the benefits — in particular, the ability to get better loans (although it can also help with insurance costs and renting). So if you’ve got that ability, there are very few reasons not to use it.
When to Avoid Refinancing
At least two situations come to mind when you might not want to refinance and only one of them is related to a credit score. However, you’ll have to use your own judgment; there might be other situations and the scenarios below might not really be that bad.
You’re About to Apply For a Large (Or Important) Loan
if you’re getting ready to ask for an important loan (such as a loan to purchase a home), think twice before refinancing. You don’t want to lower your credit scores in that situation because you might end up with a higher interest rate — and you might even get denied. For example, it doesn’t make sense to save a few bucks refinancing your (relatively small) auto loan if it means you’ll get a higher interest rate on your (relatively large) home loan.
Wait until after your important loan is approved to refinance the less important loan. The same is true if you’re going to refinance multiple loans: start with the one that benefits you the most and work your way down from there.
The New Loan Isn’t Really Better
Another reason to avoid refinancing is that you might end up in a worse position than you previously had. You might be able to get a lower interest rate or monthly payment, but what’s the trade-off?
If you refinance into a new loan, you may end up extending the term of the loan; it’ll take you longer to pay it off and the payments at the beginning of the loan will be mostly the interest. This is especially dramatic with longer-term loans — if you only have 15 years left on your mortgage and you refinance to a 30-year mortgage. With auto loans, you might not see the same effect, but you may increase your interest costs. While it may seem like you got a better deal, you might end up paying more in interest if you switch loans. Run the numbers to make sure refinancing makes sense.
You might also find that you refinance into a less friendly loan. For example, if you refinance from federal student loans to a private student loan, you’ll give up the benefits of federal loans. Likewise, refinancing a loan that you used to purchase a home might increase your risk if you fail to repay (by turning it into recourse debt).
Again, given your situation, you might want to refinance a loan, even if it’ll affect your credit or increase your risk. You’ll have to evaluate the big picture to decide what’s best.