Low credit scores don’t exist in a vacuum. They’re the result of many little decisions, infractions, and missteps. Most people don’t even realize how bad their score is until they end up denied for a line of credit. Then they get a harsh wake-up call.
That’s because so many of the factors that negatively influence credit seem harmless at first glance. If you don’t have a full understanding of how credit is reported and calculated, it’s easy to lower your credit score repeatedly without realizing you’ve done anything wrong.
If you’re thinking about refinancing your loan to get better terms, it probably seems like a smart decision for your credit health. That could end up being true, but don’t pull the trigger just yet – there’s more to the story.
Borrowers refinance their loans to save money on interest and lower their monthly payments. Lenders offer refinancing for student loan debt, car loans and, most commonly, mortgages. If your financial situation has improved since you took out a loan, refinancing is a way to cash in on that progress.
Here are some common reasons people refinance a loan:
For example, if you currently have a loan at 8% interest and you can refinance to 5% with the same remaining term, you could save hundreds or even thousands of dollars over the life of the loan, depending on the remaining balance.
Borrowers might also refinance to get a more affordable monthly payment. For example, a high-earning couple who takes out a 15-year $250,000 mortgage might have no trouble making those payments.
However, if they have a couple kids and one parent stops working to stay home, the mortgage payment might become too much. In this case, they could refinance to a 30-year mortgage to ease the pressure and decrease their payments.
Sometimes, consumers refinance in order to release someone else from the loan. A couple getting divorced might refinance so only the person remaining in the home will be on the mortgage. A child who took out a private student loan with their parent as a cosigner might refinance as an adult to release their parent from the loan.
Even though it might seem like an easy way to save money, there are some downsides to refinancing. Refinancing can restart your loan term, which might result in you paying more interest overall without realizing it.
Let’s say you have $60,000 in student loans at 7% interest with a $1,203 monthly payment and six years left. If you refinance to a new 10-year term at 4.45% interest, your monthly payment will be $321.
In this case, even though your interest rate is lower, you’ll end up paying $10,579 more in interest because your new term is four years longer than what was left on your previous loan.
If you refinance your loans, make sure to keep the same remaining term. If the lender doesn’t let you do that, keep making the same payments as you were before. Set up automatic transfer so you don’t end up being tempted to make smaller payments. That way, you could pay off the loan early. Just make sure there are no prepayment penalties.
When you refinance an existing loan, you create a whole new loan product – even if you refinance with the same bank. This can affect your credit report in a few different ways:
First, it creates a hard inquiry on your account, which will temporarily lower your credit score by a few points for one year.
Refinancing also creates a brand new credit account, which affects the average age of your credit history. If you refinance a 30-year mortgage you’ve had for 10 years, you’re effectively removing a 10 year-old account and replacing it with a new one. This will decrease your credit age, which makes up 10% of your credit score.
Borrowers looking to open a new credit line or buy a home should approach refinancing carefully. Refinancing a loan right before applying for another one might look bad to a lender.
Consumers interested in refinancing first need to look at their credit score. The type of refinancing offer you qualify for will depend on your credit score and payment history. The higher your credit score, the more likely you are to qualify for a refinance with the lowest interest rates.
Borrowers who want to refinance their mortgage usually need to have a loan-to-value ratio of 80% or less. For instance, if you have a mortgage balance of $100,000, your home’s value needs to be at least $125,000 for you to qualify for refinancing.
Consumers who want to refinance also need a stable job history, proof of income and no other outstanding problems on their credit report.
Zina Kumok is a Financial Health Counselor and Credit Counselor, certified by the National Association of Certified Credit Counselors, who writes extensively about personal finance.