Are you thinking about refinancing your car loan? It could drop your credit score in the short term but lower your car payments and possibly save you a bundle in interest. Here’s how auto loan refinancing works and the potential impact it can have on your credit score.
How Does Auto Refinancing Work?
When you refinance your car loan, you use a new loan to pay off your existing loan. The idea is to get a loan with a more competitive interest rate, and you’ll likely get a lower monthly payment as you reset the loan term. Depending on the new interest rate, you could save money if your new rate is far lower. Still, some borrowers actually pay more in interest over the life of the loan as the lender has more time to collect from you. This arrangement allows borrowers to save more money now but pay more over their lifetimes. You can modify your loan in other ways to reduce interest payments over the life of the loan or get extra cash by tapping into the gap between your old loan and a new loan with a higher principal.
How Do Credit Scores Work?
It’s ideal to understand how credit scores work before diving into how auto loan refinancing hurts your credit score. Yes, your score will go down by a few points, but it is easy to recover. In addition, knowing the components of the FICO credit scoring system will make it easier to spot opportunities to improve your score after a hard credit check. Here’s a breakdown of how your credit score is calculated:
- Payment history (35%): Payment history is the most important element that affects your credit score. If your credit card or loan accounts reach 30 days past due, the lender may report the delinquency to the credit bureaus. This negative mark could hurt your credit score by several points. However, making on-time payments on loans and credit lines will increase your credit score if they get reported to the major credit bureaus (Experian, Equifax, and TransUnion). Most lenders and credit card issuers report your payment history to the major credit bureaus.
- Amounts owed (30%): Your credit utilization ratio, or the amount of your credit limit in use, is the second most significant factor in this category. Here’s how credit utilization works. If your credit limits across the board equal $1,000 and you’re carrying a balance of $250, your credit utilization is 25 percent. It’s best to keep this ratio at 30 percent or lower to get yourself the best shot at a good or excellent credit score. Ironically, good payment history is one of the best ways to improve your credit utilization ratio. On-time payments minimize debt and make your utilization ratio better. You can also take out more credit lines to improve your utilization ratio, but it’s better to pay balances instead. Don’t stop at the minimum payment.
- Length of credit history (15%): The longer you’ve had a credit history, the better your score. There isn’t too much you can do with this category other than monitoring your accounts and keeping them open. Some people keep old credit cards open even if they never intend on using them because those financial products improve the length of your credit history.
- Credit mix (10%): Lenders want to know that you can manage both revolving (i.e., credit cards) and installment (i.e., loans) accounts. You shouldn’t take out more loans and credit lines for the sake of it, but as you add more financial obligations into your mix, your score will go up.
- New accounts (10%): applying for too much credit in a short span is a red flag to lenders and could hurt your credit score. You will usually lose a few points on a hard credit check, so getting one isn’t the worst thing that can happen to your credit score. Rate shopping through the preapproval process is an exception to the rule and will not affect your credit score. More on that shortly.
Quick note: This is the formula for the FICO score, which 90 percent of creditors use to make a lending decision. Other less popular credit scoring models, like VantageScore, use variations of this calculation or a different formula altogether. However, the key themes repeat. A good payment history and a low credit utilization ratio will help you qualify for better financing opportunities for any credit scoring model.
Will Refinancing a Car Hurt Your Credit Score?
Refinancing a car can help you get a lower interest rate, reduce monthly payments, or speed up your path to owning a vehicle debt-free. However, some people balk at the idea of getting a refinance because of how it can affect credit scores. Understanding how refinances impact your credit score is important for anyone considering this financial product. Your score will take a small hit in the beginning, but a refinance can actually improve your credit score in the long run.
Credit History Inquiry
Each time you apply for a loan product, a hard inquiry will appear on your credit report. It could drop your credit score by a few points, but the impact is usually temporary and doesn’t last longer than six months.
The FICO scoring model does not punish you for applying with multiple lenders when shopping for a new car loan. Instead, several inquiries generated in a short period only count as a single inquiry, so your credit score won’t tank. However, if you’re also applying for a personal loan, credit card, and other financial products at the same time, those hard credit checks can add up.
Closing An Established Account
Depending on how long your current loan has been open, closing the account could hurt your credit score as your average age of accounts will decrease. This category only makes up 10% of your credit score, and it will rebound as your refinanced loan ages.
Opening a New Account
To piggyback off the last point, opening a new auto loan will also lower the average age of your credit accounts. In turn, your credit score could take a hit in the short term.
How to Reduce The Impact On Credit Score
A refinance will affect your credit score, but borrowers can implement several strategies to protect their credit scores and possibly see them go up shortly after getting a new loan.
Check Your Credit First
Before applying for auto loans, know where your credit score stands. It can be lower than you expected, which could make it challenging to get approved for a loan with favorable terms. But when you check your score, you’ll know where you stand and if it’s best to work on improving your credit score before applying and getting hard inquiries on your report.
Some lenders offer prequalification tools on their websites that let you view potential loan offers without impacting your credit score. You can input your information to gauge your approval odds if you need to refinance your car loan sooner rather than later.
Fix Any Errors On Your Credit Report
The information on your credit report is used to calculate your credit score. Therefore, if you notice errors or outdated information when you review your credit report, file disputes promptly to have any information removed that could be dragging your score down.
Apply Within a Short Timeframe
As mentioned above, the FICO scoring model permits a 45-day “rate shopping” period. Therefore, try to complete your search for the perfect auto loan to minimize the impact on your credit score.
Auto Refinancing FAQs
Your credit score could dip a bit when you apply for an auto loan, and it may drop a bit more when you finalize the transaction. However, the effect is usually short-lived, and your score will start to improve over time if you make timely payments on the new loan and manage your other outstanding debt obligations responsibly.
It’s possible to refinance your auto loan with bad credit, but you’ll likely get a higher interest rate if your credit score was higher when you took out the current loan. Ideally, you want to improve your credit score before refinancing to secure competitive loan terms. But if your goal is to reduce your monthly auto loan payments, consider refinancing with a lender that caters to borrowers with less-than-perfect credit.
Is Refinancing A Car Worth It?
If you are wondering if you should refinance a car loan, this will depend on your financial situation and motivation to refinance. However, it could be a sensible move if:
- Your credit score has improved, and you believe you can qualify for a lower rate.
- The average interest rates are far lower than they were when you secured your auto loan.
- You want a more affordable car payment to free up cash for other financial goals.
- Your car’s resale value is equal to or greater than what you currently owe.
- You want to add or remove a co-borrower.
- You can afford the monthly payment but want a lower interest rate so you can pay the loan off sooner and save in interest.