Let’s Understand How Refinancing Can Hurt your Credit Score

29 Sep 2020

Most people refinance to lower their monthly payments by switching to a low-interest rate mortgage. Refinancing helps savings on the amount of interest you’ll pay in some cases. The reasons for refinancing can be many. It can be done to shorten the duration of the loan, to secure the lower interest rate, to cash-out refinance, to pay down the balance on the original mortgage, or to get rid of mortgage insurance.

But there is an important point which often borrowers ignore. When one refinances the mortgage, there is a change in the credit score. Though there will be a change in the mortgage, it will also have an impact on the credit score.

Let us find out what changes occur when one refinances:

  1. Multiple credit inquiries can affect your credit score: When you plan to refinance, you generally shop around with different lenders to understand the best rates and features possible. When a loan application is applied for, a lender reviews the credit history, which results in a “hard inquiry” on your credit reports. The effect of hard inquiries remains for about 24 hours that lower the credit scores, depending on credit history and borrowing habits. 

Therefore, before applying for the loan make a list of the lenders selectively. It will be worthy of your time and effort. Apply only to the potential lenders that you deem fit as per your understanding. 

  1. A refinance can appear on your credit reports as a new loan: When you refinance a mortgage, a new loan gets opened up. This has an impact on credit history. The overall duration of the credit history is factored into your credit scores. If an existing mortgage is a long-held account, closing it in favour of a fresh loan may negatively impact your credit score. It may lessen over time but the impact for the duration will harm your financial ratings.

  2. Skipping mortgage payments – A missed payment can negatively impact your credit score. The best way to remain updated on time is to set reminders to avoid missing on repayments. Payment history generally accounts for credit reports for the largest part of the credit score

When the refinancing part is complete, the refinancing part will have some impact on the credit score, but how the loan payment is handled after that makes all the difference. 

Before you plan to refinance a loan, make sure to understand how it could affect your finances.

Benefits of refinancing

  • Shortening the tenure
  • Lowering the monthly payments
  • Getting rid of mortgage insurance
  • Consolidating multiple loans
  • Changing loan types from fixed to variable and vice versa
  • Saving money on interest
  • Cash-out refinance

Not all cases are eligible to apply for refinancing and it is important to balance them.

Disadvantages of refinancing

Potential downsides of refinancing:

  • Early repayment fees and penalties associated with loans
  • Losing flexible repayment options and other benefits
  • Lowering the credit score
  • Increase in the tenure along with payment of extra funds in doing the whole process.

When to avoid refinancing

It would be wise to avoid refinancing which has the possibility of lowering the credit score. Unless there is a dire need of savings, do not go for the refinancing. 

The new loan will not make much difference in loan payments or tenure 

Refinancing the loan extends the tenure further. After refinancing the mortgage it will take longer to pay it off. For longer tenures, it extends further. You may not sign the better deal if it is lengthening the tenure. Before making the deal make sure to calculate the numbers using a calculator and then make the move if it is making a difference for good.

When you’re planning to apply for another loan

  If there arises the need for another loan to cater to the requirement of funds, then it would be wise to wait until the important loan gets approved. It is wise to keep the one running which is not going to save much on refinancing. Rather it would add more burden and lower your credit history. 

How long it will take to recover the credit score?

The hard inquiries performed by lenders will usually take one to two years to stop affecting your credit score. When a hard inquiry is performed after a borrower files a loan application. It stays till the time a borrower starts making payment on time and negating the effects of the loan. 

When a borrower closes the original loan by refinancing, there is a negative impact on the credit score. The new mortgage will take some time to build history, some credit scoring models will take old repayment history into account. 

It will take time to establish a payment history and raise it to the level once again. If you have significant payment history, it will be in better shape and recover more quickly.

Other options for repayments

If refinancing is not workable, one can switch to other options available. The other simplest option available is recasting your loan. You can examine your finances to discover the ideal monthly payment that will satisfy the principal and cut down on total interest payments. It may help to pay off the loan faster. 

If faster payment of the mortgage is needed, you can borrow against the equity of loan such as a mortgage. 

Summing Up 

If refinancing the loan is not necessary, it is best to avoid as much as possible. It negatively hurts the credit score and makes it difficult to establish it again. 

Usually, it takes around two years or so to build up the credit score again by regular and timely payments.