Will refinancing a loan hurt your credit score?

Refinancing and Your Credit Score

by Gary Foreman


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I purchased a 4 year old car right about 6 months back with a loan that carried a somwhat higher interest rate. I was told that I should wait at least one year before refinancing. If I did otherwise, it would look bad in my credit for not staying with this company for at least a year. I am interested in shopping around to see if I can get a lower interest rate, but I am uncertain due to the information that was given. Should I shop around or wait until a year has been completed?
Lillian

Like many of us, Lillian is concerned with her credit score. And, she should be. Not only will her credit score affect how much she'll pay to borrow money, but also, in some cases, it can make getting credit difficult or impossible.

Before we look at Lillian's question, we need to learn a little more about credit scores. The largest supplier of credit scores is Fair, Isaac & Co (FICO). The score is designed to give potential lenders an idea of how likely you are to repay a loan. FICO has demonstrated that a lower score does correlate to a greater probability of default.

FICO scores range from 400 to 900. About 700 is considered average. The exact formula used is a FICO secret. But they do provide an idea of what things go into the formula and how much weight each category is given. That should be enough to help Lillian with her question.

The advice given to Lillian is true, but probably not as important as she was led to believe. The longevity of her accounts only makes up 15% of her credit score. And that's for all of Lillian's accounts.

The score will include the oldest account she has and also the average of all accounts. So closing one account early by refinancing really shouldn't make a big difference in her score. Her average will dip slightly, but unless her score is 620 or below that shouldn't pose a problem.

The biggest determinant of Lillian's score concerns how good she's been about paying her bills on time. 35% of her score reflects her promptness in bill paying.

The amount that Lillian owes will determine 30% of her credit score. Naturally potential lenders feel more comfortable if she owes less money. Accounts that are close to their limit will lower her score.

Ten percent of the rating is based on Lillian's pattern of credit use. The 'pattern' considers how many of her accounts are fairly new and how many potential creditors have asked for her history. People with debt problems often try the same tactics. The FICO formula attempts to identify those people.

The final ten percent evaluates the types of credit that Lillian is using. The types of accounts, mix of accounts and total number of accounts she has are included. Loans with finance companies will reduce her score.

More than one company provides credit scores to potential lenders. Your score will not be the same with each provider. We've used the formula from FICO for this discussion. Other formulas are similar.

Now back to Lillian's question. She didn't mention who told her to wait. It is possible that the person who gave that advice stood to make more money if she delayed.

So what should Lillian do? The first thing is to get a copy of her credit score. Next she should check and make sure that the information is accurate. Studies indicate that about one in four reports contain serious errors. Those errors could reduce Lillian's credit score and increase the amount she'll pay to borrow money. She can obtain her score at www.myfico.com.

Want to pay off your car faster? Consider refinancing into a lower auto rate.

Unless her score is below 620, she shouldn't have to worry about refinancing now. A healthy credit score won't drop much for one account. And any drop wouldn't affect this refinancing. If Lillian manages her credit properly, it won't be important the next time she goes to borrow money either.

Once she's verified that the information is accurate, she should begin to look for lower cost financing. Identify two or three potential lenders. She'll want to contact them one right after the other. Each lender will obtain her credit score. If all those requests happen over a few days, they'll be treated as one event. If they trickle in over months, they'll tend to decrease her score.

It is possible that she won't find cheaper financing. But the only way she'll know that is if she checks some competing lenders.

Reviewed May 2017


Gary Foreman

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.

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