Refinancing a loan can help you save money. You can spend less on monthly payments, and you can even reduce the total amount of interest you will pay in some cases.
These reasons alone are enough to convince most people to pull the trigger. But what about your credit score – does refinancing negatively affect your credit?
A small, short-lived punch
You are likely to see a smaller impact on your credit scores when you refinance.
This makes sense if you understand how credit scores work: you applied for a loan, which usually has a negative effect on your credit. We’ll find some details below, but the more important question is whether or not it matters.
Refinancing can significantly improve your financial situation. If that means your score is temporarily down if you don’t refinance?
The whole point of good credit is to reap the benefits – in particular, the ability to get better credit (though it can help with insurance costs, renting and job search). So if you have this ability, there is very little reason not to use it.
When to Avoid Refinancing
At least two situations that come to mind when you may not want to refinance (only one of them is related to an emergency). However, you will need to use your own judgment – there may be other situations, and the lower case scenarios may not be so bad.
You will be applying for a large (or important) loan: If you are preparing to apply for an important loan (such as a home loan), think twice before refinancing. You don’t want to downgrade your credit scores in that situation because you might end up with a higher interest rate – and you might even decline.
For example, it doesn’t make sense to save a couple of dollars refinancing your (relatively small) car loan if it means you will get a higher interest rate on your (relatively large) home loan.
Wait for your important loan to be approved for refinancing a less important loan. The same goes for refinancing more loans: start with the one that benefits you the most, and get out of here.
A new loan is not really better: Another reason to avoid refinancing is that you end up in a worse position than before. You may be able to get a lower interest rate or a monthly payment, but what is the trade-off?
If you refinance into a new loan
If you refinance into a new loan, you will often extend the loan term; it will take longer to pay it off, and the payments at the beginning of the loan will be most interesting.
This is especially dramatic with long-term loans – if you are only 15 years old on a mortgage and you are refinancing on a 30-year mortgage.
With auto loans, you may not see the same effect – but you will increase the cost of interest. While it may seem like you have a better deal, you may end up paying more than interest if you swap loans. Run numbers to make sure refinancing makes sense.
Find yourself refinancing into a less pleasant loan
You may also find yourself refinancing into a less pleasant loan. For example, if you refinance from federal student loans to a private student loan, you will waive the benefit of federal loans. Also, refinancing a loan you used to buy a home can increase your risk of not paying it out (turning it into recourse debt).
Again, given your situation, you may want to refinance your loan – even if it affects your credit or increases your risk. You have to rate the big picture to decide what’s best.