How does refinancing car loans effect your credit score? The answer can be easy if you study the guidelines issued by Fair Isaac, the firm that developed the “FICO score”. Although we may think that refinancing will immediately boost our score due to lower payments, the truth is there are several factors that go into a FICO score. Refinancing car loans will first usually drop, then, in several months, raise credit scores due to the way the three major bureaus (Transunion, Experian, and Equifax) view specific activity in your credit file.
- Inquiries will drop the score. The bureaus will drop your score a bit because of the credit inquiry the lender that will refinance the car loan will run. It will be only a few points, however, not usually enough to worry about. A consumer typically has about two weeks to safely have his credit pulled several times without each subsequent pull causing more FICO score drop, because the bureaus encourage rate shopping. Beyond this time frame, each new pull will drop his score a few more points.
- The new account will drop a credit score initially. Because there is insufficient history on the new car loan, the bureaus will drop the score a bit. Since there is little history on the new account, they cannot gauge a repayment history, and thus this credit profile is riskier than one that shows a proven track record paying on an account for several months or years.
- The tenure built up on an old car loan will be gone, dropping the score. An active trade line that has a longer timeframe has more weight than a new account. When a car loan is refinanced, the shorter length of time on this account compared to the old account will drop the score at first. This is why a car loan should never be refinanced before applying for a mortgage loan or during the process, as a dropped score will affect the rate, fees, and qualification.
- The higher balance-to-credit-limit ratio will drop the score. In an example where the old loan had a balance of $2000.00 on an original credit amount of $6000.00, the 33% ratio of balance-to-credit line looked good to the bureaus. With the new loan, the lender will establish a line equal to that $2000.00 balance, not the original $6000.00 of course. This means a ratio of 100%, dropping your score. The lower the ratio of used credit to total credit available, the better the score.
- The good news: the refinanced car loan should soon raise the score. The good news is that within a few months, the credit score will rise again, as long as the payments are made on time. The lower monthly payments from refinancing car loans will hopefully aid the consumer to pay off other debt, further elevating the score as other balances are brought down.
Refinancing car loans can make a lot of economic sense, and will help credit scores (and the wallet) in the long run. As mentioned before, it is better to avoid a refinance if one is planning on buying or refinancing a house, as the drop in score can hurt the mortgage loan process.