How Can Refinancing Your Car Loan Affect Your Credit Score?

Interest rates and tenure of any loan play an important role. Equated Monthly Installments (EMIs) are a function of your loan amount, the rate of interest and the tenure of the loan. While you can decide the quantum of the loan required and the tenure of the loan, the rate of interest charged on a loan is a decision taken by the lender.

Quite often, when you apply for a loan, the conditions may not be favorable and hence, you might end up with a loan at higher rate of interest or a shorter/ longer tenure than expected. This might be due to a number of reasons like a bad credit score, paucity of time, interest rate cycle, etc. It may be possible that a few years or a few months down the line, you may come across a loan of the same nature that is being lent at a much lower rate of interest.

What do you do? Just sit and brood over it? No, there is an option called Refinancing of Loan, which comes across as an excellent tool to deal with such situations.

What is Refinancing of a Loan?

In Simple terms "Refinancing of a Loan is taking a new loan on better terms to pay out the old loan".

When Can You Refinance A Loan?

Ideally, a loan can be refinanced at any point in time during the tenure of the loan. Generally, the situations that warrant refinancing a loan are a change in interest rate scenario, change in income levels or moving from fixed to floating rate of interest or vice versa, poor customer service from the existing lender, etc.

How does Refinancing a Loan Work?

The process of refinancing a loan is similar to availing a new loan. Under refinancing, an individual takes a new loan with a structure different than the earlier one and pays out the former loan. This could be with the same or different lender. Though the process followed in refinancing a loan is similar to availing a new loan, it could prove less cumbersome, especially if it involves refinancing with the same lender.

Does Refinancing Work for a Car Loan?

A car loan is a loan with a long tenure of 3-7 years and can be availed at fixed or floating rate of interest. Floating rates are generally pegged to MCLR. It may so happen that the rates have gone down after you have availed a loan or your credit scores have improved significantly since you availed the car loan or any other reasons as mentioned above which may prompt you for refinancing your loan.

As a car loan is a long-term loan, it makes sense to get your loan refinanced at rates or terms as convenient and advantageous to you. However, you would need to bear in mind a few points before going in for refinancing of a car loan.

They are:

• Refinancing of any loan involves a processing fee which has to be taken into account while considering the benefits of refinancing.
• The difference in the rates of interest between the earlier loan and fresh loan should be high enough to make refinancing worth it. A small difference in rate may be lost in the processing fee payable.
• There should be sufficient tenure left in the loan to make the change beneficial.

How can Refinancing Your Car Loan Affect Your Credit Score?

You must have often heard or read that any credit action of yours affects your credit score. Right from applying for a credit to repayments to closing your credit account, all actions can have a positive or negative effect on your credit score.

Refinancing your car loan is also a credit action, as it involves closing one account and opening another in its place. Going by the common logic, it is bound to affect your credit score. You must also be aware that a credit score is assigned on the basis of past credit behavior and is dependent on certain important factors of your credit behavior.

Let us explore how refinancing a loan can affect various determinants of a credit score

Credit Accounts

Each and every credit account counts toward your credit score. When you close a running account and refinance it, the new lender may tell you that they could take care of the closure of the earlier account. However, the responsibility of the account finally rests with you as a loan is lent against your PAN.

If for any reason, your existing loan account is not closed properly and there are some outstanding amounts shown against your account, that particular credit account would go into the negative status and may negatively affect your score. Whenever you refinance your loan, it is good to take proper acknowledgment from your existing lender that your account is closed satisfactorily.

Increased Hard Inquiries

Refinancing your loan causes your lender to inquire about your credit score and credit report from the credit bureau as it is considered as a fresh loan. Also, you might need to apply with multiple lenders to check if your refinancing request will be approved. All these may see many hard inquiries being counted against your PAN which might not bode well for your credit score, especially if you are looking to apply for any other loans in the near future.

Decrease in the Length of Credit History

Credit History is also another factor that determines your credit score. A long-standing credit account that is being serviced properly (EMIs being paid on time) adds quite a lot of value to your credit profile. Lenders generally prefer lending to borrowers who demonstrate responsibility in handling credit over a long period of time.

When you close your long-running car loan account, you end up losing that part of the credit history, so you may see a sudden drop in your credit history. A new account is opened but it will take some time for you to demonstrate your creditworthiness there.

End Note

Overall, it may not seem like refinancing a car loan can have a major impact on your credit score. However, it is always good to keep in mind that while these factors do not affect the credit score individually, it is always an interplay of all the related factors.

Refinancing of any loan should be done only after a thorough cost-benefit analysis.