With mortgage rates at a record low, many Canadians are wondering if they should consider refinancing to lower their monthly payments. It’s important to understand that while refinancing can have a big impact in the long term, it can present some unavoidable hurdles in the short term that you should be aware of. As with any financial decision, be sure to assess your personal situation and determine if the benefits of refinancing outweigh the downfall so you can move forward knowing you’re making the smartest decision for your personal needs.
What Is Refinancing?
Refinancing is the process of getting a new loan with new terms and using the funds to pay off your old one. Your new terms could include a lower interest rate, a revised repayment period or different repayment rules.
Mortgages, auto loans, student loans and even personal loans all have refinancing options and while it may seem a bit redundant to refinance a loan you’ve already secured, there are many advantages that can have a big impact over the course of time.
What Happens To My Credit When I Refinance?
While you may have to sacrifice a decrease in your credit score as part of the process, refinancing can bring with it huge savings and benefits in the long term so be sure to look at the big picture before making any decisions. Refinancing can impact a few key factors that will influence your credit score:
Adds Hard Credit Checks To Your Report
A hard credit check is when the lender requests your credit history from one of the major credit bureaus. Every time this happens your credit score will decrease by several points and the record of this credit check will typically remain on your credit report for up to 2 years. The impact will depend on how many credit checks are performed and how close together they occur. A big part of the refinancing process is to shop around for better rates so to keep this impact as low as possible, make sure they all occur within 30-45 days of each other so they only count as one hard credit check.
If you’re curious about your credit report and want to see your credit score at any point during the process, you can rest assured that pulling your own credit report is considered a soft check so it won’t cost you any points.
Shortens Credit History
Refinancing can also impact your credit score by shortening your credit history. When you refinance a loan, you close that original account, and if it was one of your oldest accounts, your credit history will shorten as a result. Credit history accounts for 15% of your overall credit score so shortening it can cause your credit score to drop, sometimes significantly. If you have other open accounts that are 5+ years old and in good standing, that should help offset the impact.
Adds New Debt
Taking out a new loan means taking on more debt. When this debt is added to your credit report, your score will drop for a short period, but it shouldn’t be too substantial and will be repaired once you begin making your payments and showing you can manage that new debt.
Pros Of Refinancing
Refinancing your current loan can bring with it many perks that may cause some credit score setbacks up front, but can save you big money in the long term:
- If you’re able to make a lump sum payment on your new loan, you can refinance with a lower principal amount which will result in lower monthly payments and less overall debt to carry which could help you qualify for other loans in the future.
- Access to lower interest rates will save you money over the life of your loan and lower your monthly payments which gives you more flexibility to save/invest extra income.
- The flexibility to choose your loan term – so depending on your personal financial situation, you can extend it to lower your monthly payments or shorten it to pay the debt off faster.
Cons Of Refinancing
Refinancing can have a negative impact on your credit score in the short term by adding on hard credit checks, possibly shortening your credit history, adding new debt as well as fees you may incur along the way.
It’s important to note that the long-term benefits are often worth the short-term tradeoff. However, there are some scenarios where pursuing a refinance may not be ideal:
- If you’re in the market for another new loan (say, a car loan, for example), you’ll want to think twice about the refinancing process as you’ll risk a higher interest rate or even getting denied as a result of your choice to refinance around the same time. This doesn’t mean you can’t consider refinancing at all, it just means you should not do both at the same time.
- If you’ve shopped around for offers but none of them seem enticing enough to pursue refinancing, it’s OK to wait for the right time. Make sure you have a good understanding of what the tradeoff will be for sacrificing your credit score and history in the short term and be sure to read the fine print. Changing lenders can mean different terms and fees so be sure you’re comparing apples to apples before you make any big decisions.
Factors That Affect Credit Score
There are three main reasons why your credit score will drop as a result of refinancing. Fortunately, there are also ways to avoid big impacts and soften the blow.
There are two different types of credit checks; hard checks or soft checks. A process like refinancing requires hard checks, which entails the lender pulling your credit history from the credit bureaus and causing your credit score to drop as a result. As you’ll likely want to shop around for rates and compare results, it’s important to know that most scoring models treat inquiries within 30 – 45 days of each other as one had credit check instead of multiple individual checks which would deliver a much bigger blow to your credit score. Some lenders may even use 14-day scoring models, so to be safe, consider keeping all inquiries within a 2-week period to avoid any additional impact on your credit score.
Some scoring models will consider the payment history of closed accounts for up to 10 years! While it wouldn’t be weighed as high as the history on a current active account, you could still notice a lower credit score as a result. As you move forward with your new loan, it’ll be incorporated into your future payment history so make sure to manage your loan debt and avoid missed or late payments to keep your credit score climbing back up.
The history of your accounts plays an important part in your credit score. The length of your credit history will be shortened when you close out your current loan during the refinancing process so you can expect to see a decrease in your credit score as a result. As with most factors, the scoring model being used by the lender will determine if closed accounts are counted toward account history or not so there’s a chance it may not be an issue at all.
How To Improve Your Credit After Refinancing
If you’ve decided to move forward with refinancing and want to take extra care to preserve and improve your credit score after you’ve completed the process, there are a few different options you may want to consider:
If you’re carrying a lot of different debt, it may be wise to consider consolidating it. This process will help you corral everything into one place and provide you with an easier to manage monthly payment structure and often, a lower combined interest rate.
Dispute Credit Report Errors
It’s very important to check your credit score regularly as reporting errors could have a big impact and you won’t know about them if you aren’t checking your score. Whether you do it yourself or use an agency, filing a dispute is free so keep an eye on your report and if you notice anything fishy, report it right await avoid any future issues with your credit.
Make Consistent Payments
Payment history makes up 35% of your credit score! That means making consistent on-time payments is an easy way to boost your credit score. Although some lenders will offer you grace periods for missed payments, it’s important to make sure you pay all your bills by their due date to avoid any reports to the credit bureau. If you have accounts that are past due, start by paying the oldest one first.
Improve Your Credit Mix
Your credit mix is also a factor in your overall credit score. This refers to the types of credit accounts you have open in your name (credit cards, loans, mortgages). Despite what many people think, there are ways to build your credit score without even using credit cards. Taking out and paying back a personal or car loan is a great example of that. Lenders and creditors will want to see a diverse mix of credit in your portfolio so they can get a better idea of how you manage different types of accounts over time.
Refinancing can be a valuable option for Canadians looking to take advantage of their excellent credit score and save some money over time. Understanding what refinancing entails and how it affects your credit score is the first step toward determining if it’s the right option for your personal needs. Reach out to our team to learn more about the process and how refinancing can help you maximize your savings in the long term.