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Mortgage refinancing is a useful way to help handle your debts, access funds, or lock in favorable payment terms. It’s a common misconception, however, that refinancing can permanently damage your credit. In reality, most dips in credit from refinancing will be temporary, and a well-managed refinance will likely lead to a better score in the long run. Let’s talk through what you need to know about how refinancing interacts with your credit.
Understanding refinancing
Refinancing a mortgage uses a new loan to pay down an existing home loan. It can be used to create new loan terms as a way of resetting the length of the repayment plan, the conditions of the loan, the interest rate, or monthly installment amounts.
Different refinance options are available for different economic situations:
- A rate-and-term refinance aims to reduce the monthly payments or the overall interest on a loan, which can be done by changing the interest rate, the loan term, or both.
- A cash-out refinance allows the borrower to access cash against their home’s equity.
- A streamline refinance is often used for government assistance loans from the Federal Housing Administration or the Department of Veterans Affairs and can require less documentation and paperwork, smoothing over the process.
A typical refinancing starts with the application. The borrower submits their loan request along with information about their finances and other necessary documents. Then, an appraisal is done by an independent appraiser to check the property’s current market value. Buyers should also keep an eye on refinance rates, which can go up and down with the market. After the application is in, the lender will begin the underwriting process, reviewing your financial documents to make sure everything is accurate and that the risk is not too high. If all goes well, it’s time for closing, where the borrower and lender agree on terms for the refinancing.
Knowing how credit inquiries and loan applications are processed is important to protect your finances and your chances of getting favorable loan terms. Too many credit inquiries in a short period can have a negative effect on credit. The applications can involve a full investigation of your financial health, so it’s important for borrowers to consider if the timing is right to refinance.
Debunking refinancing myths
The refinancing process often has misconceptions attached to it. Let’s go through some of them so you can be fully knowledgeable and prepared as you work through the steps of refinancing.
A. Myth: Refinancing always harms your credit score
Many factors can affect your credit score in the long term, but refinancing is usually not one of them. The refinanced loan counts as opening a new account, a factor that can lower your credit score. Any loan requires a hard check on credit, too, which can also lower the score. However, these effects are minor and temporary. The long-term savings in monthly payments or debt-to-income ratio could potientially be worth the short-term impacts.
B. Myth: Multiple credit inquiries during refinancing drastically lower your credit score
Credit inquiries are categorized as either hard or soft checks. A hard check is when a lender checks your credit as part of a credit application or loan. These checks will lower your score for up to a few years. Soft checks, however, happen whenever your credit is checked for non-lending purposes. These don’t affect your score and are only visible to you. Credit scoring models will treat multiple inquiries for the same type of credit within a specific timeframe as a single inquiry, so it’s good to batch them together.
C. Myth: Closing old accounts during refinancing negatively impacts your credit score
The ages of your credit accounts are also a significant factor that affects your credit. Older accounts that are paid on time and in good standing are great benefits to achieving a high credit score. Refinancing involves closing the existing loan, which counts as closing an account, and can slightly lower your score. Still, the effect is typically minor and can be offset by other positive factors, such as timely payments and low credit utilization.
Understanding the impact on your credit
Keeping an eye on your credit score is easier when you know which impacts are temporary and which might take longer to improve. During refinancing, several steps in the process can lower your credit score for a short period, but the long-term savings are often more than worth it. The negative effects come mostly from credit inquiries and the opening of new credit accounts, like getting a new loan. Hard inquiries into your credit by the lender can lower your score temporarily. Opening the new loan account can drop it a few points, too, as it reduces the overall average age of your accounts.
Changes in your credit utilization ratio can also cause some brief ups and downs in the score. The refinanced loan might increase your overall debt, causing your credit utilization ratio to rise and negatively affect your score for a period.
Responsible management of the refinanced loan can lead to consistent improvements in your credit score over time. Keep your credit balances low, avoid new lines of credit, and try to create a mix of credit types to raise your credit score down the line.
Factors that influence credit during refinancing
A lender wants to look at your entire financial picture, so several factors come into play.
- The credit utilization and debt-to-income ratios: This is a measure of how much of your available credit you are using.
- Payment history and account delinquencies: Any late payments or overdue accounts will make you seem risky and reflect poorly on your credit score.
- Length of credit history and account age: Lenders look for borrowers with a long history of well-maintained accounts.
- Mix of credit types: Lenders like to see that borrowers have a diverse portfolio with different types of credit.
Strategies for minimizing negative impact on your credit
You have several strategies at your disposal to save yourself from ending up with negative effects on your credit.
Strategic timing
When applying for refinancing, consider keeping the applications within a short time period to make sure that multiple credit checks are treated as a single inquiry by the credit scoring models.
Timely payments
Keeping up with payments on all credit accounts demonstrates reliable behavior and will help preserve your credit during the refinancing process.
Low balances
High balances can reflect negatively on your credit. Keeping balances on all accounts low will keep a good credit utilization ratio on your side.
Avoid new lines of credit
Hold off on opening any new credit cards or making other major financial commitments while you are refinancing. New accounts can hurt your credit, as can additional credit checks.
Monitor your credit
Keep an eye on your credit report to avoid any surprises down the line and give yourself a chance to fix any discrepancies. Make sure to address any inaccuracies with your financial institution as soon as you can.
Disclaimer: Article content is intended for information only. It may not reflect the publisher nor employees’ views. Consult a mortgage professional before making financial decisions. Publishers or platforms may be compensated for access to third party websites.
