Credit bureaus are constantly urging us to check our credit scores for changes, so it's understandable that we can become obsessed with them. When preparing to refinance your home, you may have read about ways that it can damage your credit rating. Rest assured--as long as you stay current on payments for the loans you have, the refinancing process shouldn’t have any lasting impact on your credit score. The most important thing is that you get the best possible rate on a loan that makes solid financial sense for your situation and your goals. Still, it’s good to know how the credit agencies calculate your score, and what actions you can take, or avoid, in order to maintain the best possible credit score. Let’s dig into the details.
Overview
A lender will pull your credit report when you ask to refinance your existing home loan, resulting in what’s known as a “hard” credit inquiry. This inquiry remains on your credit report for up to two years, although it only affects your scores for the first year. A single inquiry won't necessarily lower your credit score, but multiple inquiries can begin to have a temporary impact.
The formulas used to calculate credit scores may consider the fact that people who apply for a lot of new credit at the same time may be increased credit risks. Refinancing does qualify as a new application for credit, so it can reduce your score slightly. However, this shouldn't stop you from making what might be a smart financial move.
A mortgage refinance application can reduce your scores from all three major credit reporting bureaus, but it should only be a small amount, in the range of 5 to 10 points. Furthermore, these decreases will likely quickly reverse, although it's difficult to be certain since all credit bureaus have different, and proprietary, formulas for calculating credit. In general, a mortgage refinance inquiry will have a greater impact on the score of someone with a limited credit history than someone with a deep history. In either case, the decrease shouldn't be anywhere near as much as actual negative events like a late payment.
New Loans
Mortgage-related inquiries shouldn’t count against you if they’re less than 30 days old. In addition, scoring algorithms may treat multiple inquiries that are more than 30 days old as a single inquiry if they occur closely together. This is typically the case when you're shopping for a refinance, since a large number of lenders usually pull your credit history within a short period of time.
The reason for treating multiple inquiries in this way is that they’re all for the same purpose of refinancing your home, which is different from shopping for multiple credit cards within a short period of time. In this case, your credit score see a larger negative impact, because you’re applying for different products with different credit companies. The major difference in scoring algorithms is the shopping window for the refinance. Older versions of FICO may use a window of only 14 days, while newer versions allow the window of up to 45 days.
The length of time over which you apply for refinancing is therefore more important than the total number of inquiries in most cases, since spreading them out too far could result in more than one ding on your credit score. Even if this does occur, the benefit of spending more time to get a lower interest rate should more than offset the minor, temporary impact to your credit score. Remember, you could be paying that interest for the next 30 years.
Old Loans
Closing an existing loan is another way that refinancing your home can have a temporary adverse affect your credit. The new refinance will pay off the old mortgage, causing you to lose that credit history. Older lines of credit are your credit score’s best asset, so replacing them with new lines of credit may reduce your credit score in the short term.
Furthermore, refinancing reduces the average age of your credit accounts, commonly known as your credit age. This parameter is important to many creditors, so it could impair your ability to obtain credit in the future. Again, this impact should be more than offset by the savings in refinancing your home, provided you continue practicing healthy credit habits.
Cash-Out Refinancing
Cash-out refinancing has additional implications for your credit score. This method allows borrowers to tap into the equity they have in their home, which increases the balance of the mortgage. This larger balance increases your credit utilization, which could reduce your credit score. Greater debt generally represents a higher risk for creditors, even if you’ve never missed a payment.
Summary
Refinancing shouldn’t cause you to have any significant concerns over your credit score provided make timely payments on all of your loans. The small, temporary drop in your score should only affect you if it happens to be very close to a scoring threshold, so it may be helpful to ensure your score is as high as possible when you start shopping for a refinance.
