- Refinancing a car may affect your credit, but the effects are often temporary.
- The process involves a hard credit inquiry, which can cause a slight dip in your credit score.
- Closing your old loan may also affect the length of your credit history, which may negatively affect your credit score.
- Strategies like timing your refinance and maintaining a low debt-to-income ratio may help minimize adverse effects.
- Evaluating your financial situation before deciding if refinancing is the right move is essential.
Refinancing a car loan can be an attractive option for people looking to lower their monthly payments or take advantage of lower interest rates. Refinancing may hurt your credit score, but the effect is typically minor and temporary. Here, we’ll explore how refinancing affects your credit score, why it happens, and what steps you can take to minimize any negative effects.
Understanding the Term “Refinancing”
Refinancing a car loan is the process of taking out a new loan to replace your existing loan. People often refinance their car loans to reduce monthly payments, lower the interest they pay over time, or adjust their loan terms to better suit their financial situation. This process has a few potential consequences for your credit score.
Overview of Credit Score Factors
Before diving into the specifics of how refinancing affects your credit, it’s essential to understand the key factors that determine your credit score:[1]
- Payment history (35%): Your score’s most significant factor. Timely payments positively affect it, while missed or late payments harm it.
- Amounts owed (30%): The amount of available credit you use on revolving accounts like credit cards. A lower ratio is better for your score.
- Length of credit history (15%): A more extended credit history typically helps your score.
- Credit mix (10%): It may be beneficial to have a mix of different types of credit (credit cards, loans, mortgages).
- New credit (10%): This includes recent credit inquiries and newly opened accounts, which may lower your score slightly in the short term.
How Refinancing an Auto Loan Affects Your Credit
Refinancing an auto loan can trigger several changes to your credit.
Impact of Hard Credit Inquiries
One of the common concerns about refinancing is the effects of a hard credit inquiry. When you apply for a new car loan, the lender typically checks your credit report, which often results in a hard inquiry. Hard inquiries may cause a slight drop in your credit score. Credit scoring models may see frequent credit inquiries as a sign that you may take on too much new debt.
While a hard inquiry typically lowers your score, the effect is usually short-term. Your credit score is likely to recover once your new loan is in good standing and you continue making timely payments.
Effects of Closing an Old Loan
When you refinance your car, you are essentially closing your old loan and replacing it with a new one. If you initiated your original car loan several years ago, closing it could shorten the length of your credit history. The length of your credit history is essential to your credit score, so closing an older loan may cause a slight dip. However, this effect will likely be minimal if you have other well-established accounts.
How Long Will Auto Refinancing Affect Your Credit Score?
While the effects of refinancing on your credit score can be noticeable at first, the duration is typically brief, with your score rebounding if you take care of your credit by making on-time payments. It's also important to avoid using more than about one-third of your available credit on revolving accounts.
Duration Impact on Credit Score
The hard inquiry will show up on your credit report for about two years, but it only affects your score for a few months.[2] After that, as long as you continue making timely payments on your new loan, your credit score should start recovering.
Refinancing may improve your credit score by lowering your interest rate or monthly payment, making it easier to make payments on time. This is particularly true if you can refinance and avoid missing payments or accumulating more debt.
How Credit History Can Recover Over Time
Your credit history plays a significant role in your overall score. While refinancing may cause a minor dip, your credit history is likely to recover over time. Making regular payments on the new loan is crucial to help avoid further credit score decreases.
Strategies To Limit Harm to Your Credit Score
While refinancing may cause a short-term lowering of your credit score, there are strategies you can use to minimize the effect.
Timing Your Refinance
If you’re concerned about the hit on your credit score, timing your refinance is crucial. Consider refinancing when your credit is good, and you don’t plan on applying for other types of credit (like a mortgage or personal loan). This way, you can minimize the effects of hard inquiries on your credit score.
Auto lenders may allow you to shop around for rates without negatively affecting your credit score if you make all inquiries within a short time frame (typically 30 days). When multiple inquiries are made in a short period, they’re usually counted as one for scoring purposes, which helps limit the impact.
Maintaining a Low Debt-to-Income Ratio (DTI)
Another way to protect your credit score is by keeping a low debt-to-income ratio. Lenders may consider your DTI ratio when you apply to refinance a car loan, and a lower ratio may increase your chances of qualifying for a better interest rate and loan terms.
Is Refinancing a Good Idea?
Refinancing can be a good idea under the right circumstances.
Evaluating Personal Financial Situations
Before deciding to refinance, look at your current financial situation. Refinancing may be a good option if you’re struggling to make payments or want to lower your monthly expenses. Consider your future financial plans, such as an eventual home purchase or debt consolidation before refinancing your car loan, as even a small credit score drop could influence your terms and interest rates on other loans.
Potential Benefits and Drawbacks
- Benefits: Lower interest rates, reduced monthly payments, and the ability to adjust loan terms can all be positive outcomes of refinancing.
- Drawbacks: The potential for a minor drop in your credit score and the time it takes for your credit to recover may be factors to weigh carefully.
Making the Right Choice
While refinancing a car loan may cause a slight, temporary dip in your credit score, the effects of refinancing a car loan on your credit are short-lived. The financial benefits of refinancing a car loan outweigh a slight credit score drop for many people. Ultimately, refinancing may be a wise choice if it helps improve your financial health in the long term.
