Whether you’re looking to purchase a new car for the family, move into a new apartment, or expand your business – loans help us meet all our cash shortfalls. However, while loans are readily available, you need to be cautious while relying on debts. Generally, debts are repaid in the form of monthly EMIs – which include both the principal and interest components.

Even a slight reduction in loan EMIs can reduce your overall loan burden significantly. This is where refinancing comes into the picture. However, before you opt for refinancing a loan, you need to be aware of all the potential effects. Here, in this article, we explore how loan refinancing can impact your credit score.

Before we get started, let's brush up the basics.

What is loan refinancing, and why opt for it? 

When you refinance an existing loan, you're essentially taking a new loan to pay off the existing loan. The main goal of refinancing is to reduce the burden of your current mortgage. Generally, when borrowers find better interest rates elsewhere, they switch their existing loan to a new lender. In this case, the new lender pays off the entire outstanding to the old lender, and the borrower continues repaying the loan to the new lender.

Several loans can be refinanced at lower interest rates, lower monthly payments, or longer tenures. These include:

  • Home loans 

  • Car loans

  • Small business loans

  • Personal loans

  • Credit card accounts

Borrowers refinance loans for other reasons besides reducing the rate of interest. For instance, if a borrower is not satisfied with the service offered by the lender, he/she can refinance the loan to enjoy better customer service from the new lender. 

Before you decide to refinance a loan, you need to understand the pros and cons of refinancing and how it impacts your credit score in the long run. 

Benefits of Refinancing Loans

  • Secure lower interest rate

  • Reduce your monthly EMIs

  • Change the tenure of an existing loan 

  • Save money on interest by opting for reduced tenures 

  • Change loan type – from floating interest loans to fixed interest loans and vice versa

  • Consolidate different loans into a single loan 

While refinancing has several benefits, they have certain downsides as well.

Cons of Refinancing 

  • Increase the overall tenure of the loan by opting for more extended repayment periods

  • Refinancing costs and other penalties like early repayment fees especially for bigger loans like home loans 

  • Losing flexible repayment benefits and other benefits offered by your current lender 

  • It can lower your credit score

If you're looking to refinance an existing mortgage, it's highly recommended that you consult with a financial advisor and understand the implications before making a move. Refinancing without understanding all the consequences can impact your financial wellness, especially your credit scores.

How does refinancing affect your credit score?

Before you opt for refinancing, you need to check your current credit score. The higher your credit score, the lower will be the interest rates you can avail. As the interest rates reduce, the overall burden of your loan reduces as well. Every time you place a request for your credit score from a credit bureau, it leads to a soft inquiry. Note that soft inquiries do not impact your credit score.

However, every time a third-party i.e., the lender requests for your credit score, it leads to a hard inquiry. Hard inquiries impact your credit score, and your score can take a minor hit. This is why financial advisors recommend not to approach multiple lenders at the same time.

When various lenders run a credit check on your account, there are numerous hard inquiries, which can reduce your credit score. Thankfully, today several credit bureaus club together multiple inquiries made within a month as a single inquiry. So, if you're looking to refinance your loan, it's highly recommended that you shop around within the shortest time frame possible. This way, there are not multiple inquiries on your account.

Furthermore, your credit score takes a hit when you refinance an existing loan. Yes, that may sound counterintuitive to the process. But, refinancing takes a toll on your credit score. To understand this better, let's take a look at how credit bureaus calculate your credit score. Generally, bureaus track your loan repayment history to determine your credit score. When you repay loans on time, it improves your credit score. On the other hand, delayed repayments or missed EMIs reduce your score.

When it comes to refinancing, you’re essentially cutting a loan short and shifting it from one lender to another, which reduces your credit score. 

How long does it take for the credit score to recover after refinancing? 

Seeing your credit score drop after refinancing can be disheartening. However, no worries, as this drop in credit score is only temporary. It takes around one or two years for your credit score to recover from this impact. However, you can speed up the process by repaying your loan EMIs on time and strengthening your repayment track records. 

In the long run, it takes a couple of years to bring your credit score back to previous levels. However, remember that the situation varies from one borrower to another. If you have another loan, which you're repaying on time, then your credit score is likely to be in better shape. And, you can recover quickly from the impacts of refinancing.

Alternative Options to Refinancing

If you don't want to risk lowering your credit score by refinancing, you can check out other alternative options. Some alternatives include asking your lender for a lower interest rate, restructuring your loan with your current lender, avail top-up loans, or change the type of loan from floating-rate to fixed-rate and vice versa.

Should you go for refinancing even if it impacts your credit score? 

There's no single answer that works for all. While refinancing impacts your credit score in the short-term, it's worth it if it reduces your loan burden significantly. Just ensure that you make an informed decision after considering all the pros and cons, and the consequences.