The recent drop in interest rates has increased many homeowners’ interest in refinancing.
While refinancing a mortgage can help homeowners save thousands of dollars over the life of their loan, the decision comes with several considerations for the future.
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One of these considerations is the impact on your credit score.
In this article, we’ll explore how refinancing can negatively and positively impact your credit score over time so you can make the most informed decisions.
What does it mean to refinance a mortgage?
When a homeowner refinances their current mortgage, they replace it with a new loan.
Homeowners often choose to do this for the following reasons:
- Attain a lower interest rate
- Adjust their loan term (or length)
- Access the equity they have in their home
Your new loan pays off the old one, and you only make payments on your new loan.
Types of refinancing: Rate-and-term and cash-out
The two main types of refinancing are rate-and-term refinance and cash-out refinance.
Let’s take a look at each type in greater detail.
Rate-and-term refinance
Rate-and-term refinancing allows homeowners to adjust their interest rate, loan term or both.
If interest rates are lower than when you originally got your mortgage or if your credit has improved, you may be able to acquire a lower rate to reduce your monthly payments.
Homeowners also can choose to lengthen or shorten their loan term, such as from 15 to 30 years or 30 to 15 years.
Cash-out refinance
A cash-out refinance allows homeowners to tap into their home equity by taking out a larger loan than their current balance.
The difference between the loan amounts is given to the borrower in cash.
Homeowners can use the cash for any purpose, including debt consolidation, home improvements or other large expenses.
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Does refinancing hurt your credit score?
Refinancing your mortgage can both positively and negatively impact your credit.
Fortunately, the negative impacts are typically minimal and temporary and result from the credit inquiries your lender must perform to approve the loan.
Let’s look at the potential negative impacts of refinancing on your credit.
Credit Inquiries
When you apply for a mortgage refinance, most lenders conduct a hard credit inquiry to gain access to your full credit report. (This inquiry, often called a “hard credit pull” or a “hard pull,” involves contacting all three of the national credit agencies. Such an inquiry is made every time you apply for any kind of financing.)
Hard pulls inevitably result in a small dip in your credit score—typically between five to ten points. Multiple inquiries can have an even larger effect.
Unlike most other mortgage lenders, Compass Mortgage initially performs a “soft” credit pull that does not impact your credit because we contact only one of the credit agencies rather than all three. We do not conduct a hard inquiry until final approval.
Average age of credit accounts
Credit age is one of the factors that affects your credit score.
Refinancing involves opening a new mortgage account, and this can lower the average age of all your credit accounts.
Thus, refinancing can temporarily lower your credit score, especially if you don’t have other long-standing accounts.
Credit utilization
Another key factor in determining your credit score is credit utilization, which represents the percentage of your available credit you are currently using.
Cash-out refinancing can raise this ratio because it increases your overall debt.
Short-term and long-term impacts on credit
Refinancing can negatively affect credit in the short term but can positively impact your financial health over the long term.
Let’s look at the immediate changes to your credit and the long-term benefits over time.
Immediate changes
The immediate changes to your credit will occur soon after applying for a refinance loan.
You may temporarily see a five- to ten-point drop in your credit score as it adjusts to the hard credit check and to the closing of one mortgage loan account and the opening of another.
If there are no other major changes to your credit, the short-term impacts should be resolved within months.
Long-term benefits
Although you may experience an initial dip in your score, the long-term benefits should outweigh any initial decline.
Let’s discuss the reasons why this happens.
On-time payments
One of the top factors impacting an individual’s credit score is payment history.
Consistent, on-time payments over time will boost your credit score and help offset the temporary credit dip from the refinance process.
Improved debt-to-income (DTI) ratio
Lowering your interest rate through refinancing improves your overall DTI ratio.
While your DTI ratio isn’t a part of your credit score, it is an important metric lenders use to gauge a borrower’s financial health.
Thanks to a reduced interest rate, lower monthly payments free up more of your income, and a lower DTI ratio makes it easier to manage debt and qualify for future loans.
Debt consolidation (with cash-out refinance)
If you plan to use a cash-out refinance to consolidate your high-interest debts, this can help you lower your credit utilization ratio and boost your score.
However, you will initially increase your total debt with a cash-out refi, so remember to weigh the risks and benefits carefully before taking this route.
Avoid applying for new credit during the process of refinancing
Borrowers should not apply for new credit, such as a car loan or credit card, before or during refinancing.
This can negatively impact your credit, DTI ratio and overall financial health.
It can also halt the loan process because it signals to your lender that you’re increasing your debt load.
Start the loan process with Compass Mortgage
The bottom line is that while refinancing can temporarily affect your credit score, the long-term benefits often outweigh the initial dip.
Apply today with Compass Mortgage and experience the benefits of a soft credit inquiry.
Ready to refinance? Start the refinance process today!