Refinancing is undoubtedly a clever way of saving a great deal of money. It also reduces the interest and monthly instalment you need to repay a loan. However, there is a saying that refinancing affects your credit score significantly. So should you go for it?
To understand the terms better and their interrelationship, let us discuss both.
What is refinancing?
Refinancing is simply a way to repay your previous loan with a new one. Refinancing is in practice for quite a long time. People generally refinance in order to enjoy the advantage of an easy-going loan, with lower monthly payments, and interest rates. Refinancing options are available for mortgages, student loans, auto loans, and personal loans.
What is credit score?
A credit score is a numerical expression based on a level analysis of a person’s credit files, to represent the creditworthiness of an individual. A credit score helps a lender decide whether they should approve a loan or not after taking into account your borrowing history. A credit score is primarily based on credit score information usually sourced from different credit bureaus.
Types of credit scores
You may have different credit scores. There are many types of scoring models, which define your credit score differently. Though most people rely on their FICO scores for important loans such as a car or home loan, most other scoring models look for similar criteria and make sure that you have a practice of paying your loans back on time.
The FICO score assesses your debt history and sees if you have any existing loan. Scores may range between 300 and 850. The following parameters make up the credit score of an individual:
- 35% Payment History – You have probably missed payment dates or defaulted
- 30% Amounts Owed – Assesses how much amount you owe or are maxed out
- 15% Length of Credit – You are new to borrowing
- 10% New Credit – You have applied for many new loans in the recent past.
- 10% Type of Credit – You have a healthy mix of debts.
Nowadays, some alternative credit scores are also considered which depends on whether you pay your utility bills, rent, and other bills.
What are the likely effects of refinancing on credit score? What are the solutions?
While applying for new loans, creditors pull your credit report. This may result in generating hard inquiries, which may further affect the credit score. The easiest way to avoid this is utilizing smart rate shopping strategies. Also, make sure that all applications are made within 14-45 days duration. This will enable all your inquiries to be counted as a single one.
When you apply for refinancing, your existing loan will be closed and you will start with a loan having a new open date, and no payment history. What happens here is some scoring models will not take into account your closed loans, but some will. The models which will consider your previous loan may assess if you took a very long time repaying your old loan. In that case, your credit scores may drop. However, do not worry. Applying for a new loan will close your old loan, and will also add to the number of accounts, which is, of course, an advantage.
When not to refinance?
While refinancing may seem one of the most lucrative ways to repay an existing loan, you must be careful about whether the option is really worth it. For instance, you should never opt for refinancing if-
You are looking to apply for a large loan: In the case of a large or a really significant loan, such as a home loan or a car loan, make sure you think twice before applying for a refinance option. Opting for refinancing in case of large loans can result in higher interest rates on the future loans you may take. You can even be denied a loan altogether.
The new loan is not really as good as compared to the previous one: You may take up a loan to pay off an existing loan, but that may, in turn, lead you to a greater distress than the previous one. Of course, you might get a lower interest rate and monthly payment, but there is no point in extending the loan term. In addition, the amount that you will be repaying initially is more likely to be interest. For longer term loans, the problem is profound.
For instance, you have a 10-year old auto loan, which you got refinanced to a 20-year loan. You may think it to be a better deal, but you will have more interest to pay, because of the increase in the repayment tenure.
Also, there are chances that you might end up refinancing into a much less favorable loan. For instance, if you switch to a private student loan from a federal students’ loan, you stop enjoying the benefits of all federal loans. Similarly, refinancing a home loan may end up in a recourse debt if you fail to repay it off.
Refinancing is a tricky thing to go for and it is always wise to look for the pros and cons of this practice before applying for a new loan. Decide whether you really need refinancing and if it will suit your other financial ventures in the long term.
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