Refinancing a car loan could get you better loan terms and free up funds in your budget. But how will it affect your credit score?
That’s a valid question, and the reality is you’ll likely see a small drop in your credit score. Still, you shouldn’t necessarily steer clear of refinancing just because of a temporarily lowered score, as it could be a sound decision that results in tremendous cost savings or much-needed financial relief.
How refinancing a car loan affects credit
Each time you apply for a loan, a hard credit inquiry is generated, which could result in a slight dip in your credit score. Hard inquiries remain on your credit report for up to two years but only impact your score for up to 12 months. Consequently, refinancing a car loan — which involves applying for a new loan — could temporarily ding your credit score.
Refinancing also lowers your average age of accounts, leading to a possible decrease in your credit score. The good news is the length of your credit history only accounts for 15 percent of your credit score, which means it can bounce back quickly by responsibly managing your new auto loan and other debt accounts.
How to limit harm to your credit score
Although your credit score may drop when you refinance, there are ways to minimize the impact:
- Get prequalified. Shop around to find the best deal on refinancing. Once you have a shortlist of preferred lenders, get prequalified to view potential financing offers without affecting your credit score. Plus, you’ll avoid taking several hits to your credit score by only applying with lenders that are a good match for your financial and credit profile.
- Apply within a certain window. If you submit loan applications within a 14-day timeframe, most credit scoring models will group them into a single inquiry. This is referred to as rate shopping and can also minimize the impact on your credit score.
- Make timely auto loan payments. The most significant component of your credit score is your payment history. It accounts for 35 percent, so paying your loan on time each month will help your credit score bounce back sooner than later.
- Refrain from opening additional credit accounts in the short term. Your credit age will decrease when you refinance. However, holding off on opening new credit accounts after refinancing will help improve this number and possibly raise your credit score over time.
How refinancing a car loan works
When you are ready to refinance your auto loan, follow these steps to make the process more seamless:
- Check your credit. Review your credit report to ensure it’s free of errors, and file disputes to resolve any issues you find. It’s equally important to check your credit score to know where you stand, as you’ll likely need at least a 670 to secure a new loan with attractive terms.
- Find the best loan offers. There is no shortage of auto loan refinance options, so you will need to shop around to find the best deal. Consider reading reviews and getting prequalified to view loan offers you may qualify for.
- Submit a formal application. Most banks, credit unions and online lenders feature simple online applications — or you can visit a branch or call in to apply. You could receive a lending decision immediately, but the financial institution may take a bit to finalize the closing documents.
- Seal the deal. Review the loan documents and address any questions or concerns with the lender. Sign on the dotted line, and the new lender will provide you with a check to pay off your current loan or directly take care of the transaction.
When to refinance your car loan
There are several reasons why refinancing your auto loan could make sense. However, you should only move forward when the time is right.
If auto loan rates have dropped since you took out your car loan or your credit score has improved, and you can now qualify for a better rate, refinancing is worth considering. This is also the case if you secured financing through the dealership and your bank or credit union has a better deal available.
Refinancing is also sensible if you’re going through a rough financial patch and need to lower your car payments to free up cash. Even if you receive the same interest rate, the lender can extend the loan term to give you more time to pay. Keep in mind that you may pay far more interest over the life of the loan, despite getting a lower monthly payment.
You should also refinance if you need to add or remove a co-borrower to the loan.
Refinancing a car loan can temporarily hurt your credit score. However, the financial benefits you could receive may significantly outweigh a drop in credit rating. There are also ways to minimize the impact on your credit score and help it rebound relatively quickly when you apply for refinancing.
Before deciding if refinancing makes sense, familiarize yourself with the process to avoid any surprises. Also, explore lenders, get prequalified and run the numbers to make an informed decision.