Good credit scores are extremely important when it comes time for financing. Credit scores primarily determine the terms and conditions of loans and mortgages. When car owners want to refinance car loan agreements, one of the most common questions is, “Does refinancing hurt your credit?”
The answer is both yes and no. Taking out a new loan or opening a new credit card account will usually have a brief negative effect on a person’s credit score. The score will drop a couple of points soon after the bank approves a loan because it makes a “hard inquiry” when the lender does a deep dive into the applicant’s credit report.
Understanding credit scores: Hard inquiry versus soft inquiry
FICO® is the most widely used credit scoring system by lenders. Five factors go into the algorithm that calculates the FICO® score. They include payment history (35% of score), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%).
The possible score reduction affects the “new credit” category when a lender makes a hard inquiry on the applicant’s credit report. The impact is not too large since this variable is not as heavily weighted as others in the algorithm. It’s also temporary – in most cases, those points are added back after a few months if the borrower makes timely payments.
A “soft inquiry” is different. Many online lenders offer a pre-approval application that clearly indicates there will be no effect on your credit score. That means they’re making a soft inquiry, which is basically a check on your score and any negative marks that you might have. They don’t dig any deeper than that until you apply.
Taking on too much debt can lower credit scores
Refinancing a car loan lets you pay off your old loan with a new one that should have better terms. There may be a brief period after you get the new loan when it looks like you’ve taken on added debt. This occurs when the new lender reports the new loan before the old one is paid off.
Consumers should not be alarmed if they see a substantial drop in their credit score after refinancing. Between the hard inquiry and reporting lags, the downgrade could be several points. Those will come back with time. Focus on getting monthly payments out on time and reducing debt as quickly as possible because that moves the needle on credit scores.
Lowering monthly payments by refinancing an auto loan can provide much-needed financial relief, especially as consumer prices continue to rise. It’s also an opportunity to possibly improve your credit score by using the extra money to pay off more of any other debts each month. Don’t just pay on time. Consider paying extra when it’s available.