Refinancing your car loan can be a great financial decision in the long term. Depending on the terms of your refinance, it can help you significantly reduce the amount of money you pay in interest or lower your monthly payment. This can inject some much needed cash into your budget. However, it’s also important to understand how refinancing your car loan impacts your credit score before deciding whether to move forward.
In most instances, refinancing your car loan will temporarily lower your credit score. However, your credit rating should bounce back quickly as you make your monthly payments. In the long run, the financial benefits associated with car loan refinancing usually outweigh the drawbacks of this temporary reduction in your credit score.
There are several factors which contribute to your credit score. These factors vary slightly depending on the credit scoring model being used. For FICO scores, the most commonly used credit scoring model, the following categories are used to calculate your score:
Refinancing a car loan can impact several of the categories listed above, resulting in a temporary reduction in your credit score.
When you apply for a loan, the lender will perform a credit check. These hard credit inquiries contribute to the new credit section of your credit score. If lenders see an increase in hard inquiries, the potential addition of new credit can be a sign that you may have more trouble paying back your existing debt. This may potentially cause your score to dip (usually no more than 5 points). While the hard inquiry remains on your credit report for about a year, its negative impact on your credit score will usually disappear within a few months.
It’s important to understand that the way these hard credit inquiries are structured will have an impact on how much your credit score is lowered. Credit scoring models use algorithms to evaluate the credit inquiries being made. When multiple credit checks are made for the same type of loan within a short period of time, it indicates that you’re shopping for the best rate, and these will only be listed as one hard inquiry on your credit report. This will limit the amount that these inquiries will lower your credit score.
Each scoring model’s algorithm uses a different time window when determining whether to list these credit checks as a single hard inquiry or multiple inquiries. Depending on the model, this time period may be anywhere from 14-45 days. Therefore, you should make sure that all your loan refinance applications are submitted within a short time window to limit the damage to your credit score.
Credit scoring models such as FICO look at the ratio of total credit in use compared to your total available credit. When this ratio is very high (i.e., you’re using a larger percentage of your total available credit), it can have a greater negative impact on your credit score. When you refinance your car loan, your existing loan will be closed out and replaced with your new loan. This will temporarily lower your total available credit, causing your credit score to drop. However, this dip in your credit score will quickly bounce back as you begin making payments on your new loan.
Opening new credit accounts may signal that you’ll have trouble paying your existing debts. Therefore, when you open a new car loan account as part of your refinance, it may temporarily cause your credit score to drop. However, the balance of the new car loan will be nearly identical to the balance of the old one, so this dip in your score should correct quickly.
Closing your old car loan may decrease the average age of your accounts and cause the length of your credit history to drop. As long as your car loan isn’t the only credit account (or one of a very small number of accounts) on your credit report, this drop in your credit report will likely be minimal.
There are several steps you can take to minimize the negative impact that refinancing your car loan has on your credit score:
The better your credit score, the lower the interest rate you’ll qualify for when you refinance your car loan. The following steps can help you improve your credit score prior to applying for your refinance:
While you’re likely to experience a temporary drop in your credit score after refinancing your car loan, the benefits of refinancing often far outweigh this drawback. Refinancing a car loan can help deliver several important benefits, including:
These benefits can infuse much needed cash into your monthly budget, and it can help you save a significant amount of money in the long run. As long as you make your monthly car loan payments on time, your credit score should bounce back quickly after you refinance. At this point, you will be able to reap the benefits associated with better loan terms while continuing to build a better credit score than would be possible with the onerous terms of your existing loan.
At iLending, we’ve developed a process that makes refinancing your car loan easy. Our exclusive You First Approach™ has been created to provide a great overall experience that is truly hassle free:
Refinancing your car loan has never been easier. Start the refinancing process today.