How Does Refinancing Affect Your Credit Score?

If you have a loan and its terms don't quite suit you, don’t stress! You could try refinancing your loan to lower your monthly loan payments. Refinancing is the process of getting a new loan with new terms and using the funds to pay off your old loan. Your new terms could include a lower interest rate, a longer or shorter repayment period, or different early payoff rules. 

Refinancing can be beneficial for your finances in the long run, but it can temporarily lower your credit score. Whether it affects your credit score a lot or a little depends on several factors. If you're thinking about refinancing, keep reading to learn the different ways refinancing could impact your credit score, along with ways to minimize impacts to your score.

When you refinance your loan, you apply for a whole new loan and use the funding to pay off your old loan. This process can impact a few key factors that influence your credit score.  Here are the different factors that are affected when you refinance your loan:

• Refinancing adds hard credit checks to your credit report

• Refinancing shortens your credit history

• Refinancing impacts your payment history

• Refinancing adds new debt to your credit report

Refinancing Adds Hard Credit Checks to Your Credit Report

Since refinancing requires you to submit an entirely new loan application, lenders will do their due diligence even if you've already been a customer for some time. Your lender will perform a hard credit check when reviewing and approving your application. A hard credit check will temporarily lower your credit score by a few points. Hard credit checks account for 10% of your credit score. 

The total number of hard checks listed on your credit report also impacts your credit score, but don’t let that discourage you from looking around for the best rates. If you apply for the same type of loan with multiple lenders in a 45-day period, it may only show up as one hard check on your credit report, depending on the credit bureau’s scoring model. 

Most hard credit inquiries will stay on your report for 3 years, but they tend to lose weight as they age. Hard credit checks can temporarily ding your credit score by a few points, but the long-term benefits of finding a better rate on a loan usually outweigh this short-term dip. 

Refinancing Shortens Your Credit History

Another way refinancing can impact your credit score is by shortening your credit history. When you refinance a loan, you end up closing that account. If this loan was your oldest credit account, closing that account will shorten your credit history. This includes the length of your credit accounts and the average age of all the credit accounts listed on your credit report. 

Your credit history is an important factor when determining your overall credit score. Credit history accounts for 15% of your credit score. Shortening your credit history will cause your credit score to drop, sometimes significantly. If you have other credit accounts open in good standing that are at least 5 years old, their credit history will help you minimize the credit score impact when refinancing a loan. Your credit cards, cell phone account, and mortgage can all help you maintain a long and healthy credit history.

Refinancing Impacts Your Payment History

Thirdly, if you've been consistently making payments on your loan for years, these on-time payments have been reported to Canada's credit bureaus. Payment history is the most important factor that impacts your credit score, accounting for 35% of your credit score. Closing an existing loan could reduce the impact that your on-time payments has on your credit score, depending on the credit bureau and scoring model used. 

For example, Equifax lists closed accounts on your credit report for up to 10 years if the lender reports them as “paid as agreed.” That said the payment history of a closed account may not be as impactful as  the payment history of open accounts.

This loss can lower your credit score, especially if you do not have many other credit accounts with consistent payment history. However, making on-time payments on your new loan will build up your history and help you recover from any sudden changes to your credit score. 

Refinancing Adds New Debt to Your Credit Report

Finally, if you take out a new loan, you’re adding new debt to your credit report. When new debt is added, your credit score will drop for a short period. Since refinancing is technically taking out a new loan, it may cause your credit score to drop. However, this drop should be small, and your credit score should recover quickly.

How Does Refinancing Different Loan Types Affect Credit Scores? 

There are several different types of loans that you can refinance, including mortgages, auto loans, and personal loans. Here’s what happens to your credit score when you refinance each type of loan.

Refinancing a Mortgage

A mortgage is most likely what comes to mind when you think of refinancing, and that's because refinancing your mortgage is very common. Refinancing a mortgage helps you find more favourable interest rates and terms as your finances change. Since a mortgage term is very long, usually 25 years for most Canadians, it's common for your lending needs to change during the term. You might refinance your mortgage to take advantage of lower interest rates, borrow more money against your home equity, or lengthen or shorten your mortgage length. 

If you've had your mortgage for a while, refinancing may drop your credit score due to hard credit checks being made, your credit and payment histories shortening, and new debt being added to your credit report.

Here’s what you can do to minimize credit score impacts when refinancing your mortgage:

• Shop around in 45 day time-frames: When you’re looking around for better mortgage rates, try focusing your efforts into 45 day windows to prevent multiple hard credit checks from being added to your credit report. You can also use tools like Borrowell to shop around for mortgages and see your approval chances without a hard credit check (checking your credit score with Borrowell is a soft credit check and does not impact your credit score).

• Ensure you make all necessary payments: When you refinance your mortgage, you may receive a cash-out from your new lender to make a final payment on your old mortgage. When transitioning from your old mortgage to your new one, don’t forget to make your final payment on your old mortgage on time! Forgetting that last payment, even if your cash-out hasn’t arrived yet, can have a substantial negative impact on your credit score. Your credit score could drop if you miss a payment on your old mortgage during the refinancing process.

Refinancing an Auto Loan

Refinancing a car loan is a common occurrence, especially if you still owe money on an older car and you are looking to purchase a new vehicle. In this case, your lender might refinance your new loan to include the remaining balance of the old loan. This tactic is commonly known as rolling your old balance into your new balance. 

If you are using this tactic, you should be careful not to borrow more than the car is worth. If you refinance your car loan to get lower monthly payments on a longer term, it may increase how much you end up paying for the car. If you’re unable to pay off this new debt in a timely manner, this could negatively impact your credit score. Make sure that your new terms don’t impact your ability to make payments in the long-run.

Refinancing a Personal Loan

A personal loan is an unsecured loan with a financial institution that is paid back in regular installments. These loans are usually for a lump sum, and the lender uses your financial profile to qualify you for the loan (versus a secured loan, which uses an asset to secure the loan). You have many refinancing options when choosing to refinance your personal loan, including:

• Increasing the loan amount to access more cash for a needed purchase

• Lowering the interest rate thus reducing the monthly payment

• Increasing the time to pay off the loan thus lowering the monthly payment

Like other refinances, refinancing a personal loan means paying off your old loan and replacing it with a new loan. Refinancing will have the consequence of lowering your credit score due to hard credit checks being made on your credit report and your credit and payment histories being shortened.

How Do I Minimize the Impact Refinancing has on My Credit Score? 

When you refinance a loan, whether it's a mortgage, personal loan, or car loan, your credit score will likely drop, at least temporarily. You can prepare for this by obtaining a copy of your credit report from one of Canada's leading credit reporting bureaus. You can sign up for Borrowell to download your Equifax credit report for free.

Once you’ve downloaded your credit report, check for vulnerabilities with the loan that you are planning to refinance. Is it your oldest credit product? Do you have other loans, or is this loan the bulk of your credit report? Answering yes to these questions means it's likely your refinance could have a more significant impact on your credit score.

If this is the case, you can minimize the impact of refinancing using the following strategies:

• Keep older credit accounts open: If you have other credit accounts that are older, such as a credit card, consider keeping those accounts open, even if you don't use them right now.

• Make payments faithfully: Ensure you make your payments on your new loan faithfully. The easiest way to accomplish this is to set up auto payment either from your chequing account or your credit card.

• Maintain your credit mix: If you only have a few different types of credit accounts, refinancing a loan could cause a drop in your score. Maintaining other types of credit will mitigate this drop.

What are some other things I should keep in mind before refinancing?

Refinancing a loan is an excellent way to find lower interest rates or restructure your loan to suit your needs. When done properly, refinancing your loan can have many long-term benefits. But when done haphazardly, refinancing your loan can have some drawbacks. Here are the top factors to consider when considering refinancing a loan:

Pros

• Lower interest rates: Refinancing your loan for a lower interest rate will save you money over the life of your loan and lower your monthly payment, opening up more room in your budget for other goals like savings and debt repayment.

• Lower principal: If you can make a lump sum payment on your loan, you can refinance with a lower principal amount, resulting in more affordable monthly payments and less debt overall, which can help you qualify for other types of debt like a mortgage.

• Shorter or longer terms: When you refinance, you are taking out a new loan, which means you can pick your loan term. You can extend your loan term to lower your monthly payments or shorten it to pay off the loan sooner.

While there are many benefits of refinancing, there are also some drawbacks, including:

Cons

• Credit scores can drop: Hard credit checks from lenders can cause a temporary drop in your credit score.

• Credit history can be impacted: If your loan is your oldest credit tool, eliminating it from your credit history could cause a more significant drop in your credit score. 

• Fees and penalties: Refinancing your loan, especially mortgages, can entail fees, so you must consider the total refinancing cost.

The Final Word on Refinancing and Credit Scores

Whether or not to refinance your loan depends on your individual preferences. There are many upsides, and the downside comes down to whether the fees outweigh the savings and the potential hit to credit scores. Setting aside the fees question, the drop to your credit score only matters if you plan on applying for more credit products in the immediate future. If the answer to that question is no, then it's likely that your credit score will completely recover before you need to rely on it again. If you follow the suggestions above to make sure your credit score recovers quickly, the long-term impact of refinancing on your credit score will likely be minimal.

Thinking of refinancing your loan? Before you start, make sure to find out where your credit score currently stands. Sign up for Borrowell to get your free credit score and download your Equifax credit report for free. You’ll know where your credit score is starting off from, and you’ll see how your different credit accounts are impacting your overall credit health.