Many homeowners wonder if refinancing their homes will hurt their credit scores. The truth is that it depends on several elements such as the time frame for hard credit checks, multiple loan applications, closed accounts, debt-to-income ratio, and knowing how to maintain a solid credit score during the process. In the end, how refinancing your mortgage affects your credit is all in how you play your hand.
This article examines the home refinancing process, how it may affect your credit, and how to plan and determine if refinancing is the best solution for you. With a firm understanding of the process and a concrete strategy, it is possible to refinance your home without adversely affecting your credit score.
Does Refinancing a Home Hurt Your Credit Score?
The extent to which refinancing your mortgage will affect your credit score will depend on how often your lenders will check your credit, what type of credit check it is, and what type of new refinance loan you will receive. While pulling your credit score may have a short-term effect on your score (less than two years), taking on more debt will have a much larger impact.
Home Refinancing and Your Credit Score
Mortgage refinancing is an effective tool to lower your interest rate and your monthly payment when you need it most. It may or may not hurt your credit score, depending on how you approach the process. Therefore, it is essential to understand the effect on your credit and the components, strategy, advantages, and disadvantages of refinancing your home.
Home Refinancing and Your Credit Score
One of the most proactive things you can do to protect your credit score is to continue making mortgage payments on your old loan no matter how close you are to refinancing it. You are responsible for making each payment until the moment it is officially closed. Late payments or non-payments will adversely affect your credit.
Hard Credit Checks vs. Soft Credit Checks
Let’s first understand the issue of how hard and soft credit checks affect your score. Hard and soft credit pulls are not the same. It is important to understand these terms and how they work.
Hard Credit Checks
Experian describes a hard credit check as a creditor’s request to view your credit file to determine if they want to proceed with opening a new credit account with you.
Hard pulls slightly lower your credit score temporarily and stay on your credit report for up to two years before being purged. A hard pull for a new account only accounts for 10 percent of your score, but they add up when you have multiple hard checks. The best advice is to use them sparingly, even if you are refinancing often.
Soft Credit Checks
Soft credit checks are implemented when you check your own credit files. They also occur when a creditor performs a preliminary review before you complete a full loan application with them. Soft pulls do NOT affect your score in any way.
How Refinancing Affects Your Credit
Refinancing your home loan will affect your credit, but understanding why and how it affects you will help minimize the level of the negative impact it causes. Understanding the three ways it affects your credit score is beneficial in creating a strategy.
Experian lists three points to consider:
1. Hard credit checks
When you apply for a home refinancing loan, lenders will perform a hard credit check. This can lower your score temporarily, but it will recover as you make on-time payments and other factors.
2. Multiple loan applications
As you submit multiple loan applications and each lender performs a hard credit check, it will lower your score. However, if all the hard pulls are done within a 14-day period, the impact will be less than if the checks are spread out over many months.
Performing the hard checks over several months may even leave a long-lasting negative impression that is difficult to remove. This is because this will appear like you are applying for a lot of credit accounts at once, which spooks lenders. As a result, your score may take a hit. Good research and planning can save your nerves and your credit from unwanted counterproductive consequences.
3. Closed accounts
Once your refinancing loan is executed, your old loan becomes closed. Note that longstanding accounts improve your score, so when you close one, it removes the positive impact it contributed to your credit, lowering your score. Also keep in mind that if your old loan was in good standing, the hit to your credit will not be as dramatic as it would if it was not.
The effect refinancing your home loan has on your credit score can be minimal. Having a clear comprehension of the refinance components helps achieve this goal.
Refinance Components
Because the foundation of a home loan is based upon the consumer’s ability and promise to repay the loan, specific components comprise the mortgage. It is a good idea to understand what these elements are in that they may determine or be determined by your credit score.
Face Value
The face value of a refinancing loan is the total amount of the loan and the amount the homeowner promises to repay.
Term
The term is the time frame of the loan from the beginning to the expiration date.
Amortization
Amortization refers to the number of years contracted to repay the loan in full.
Interest Rate
The interest rate is the percentage of the money owed to finance the loan.
Compounding Frequency of the Interest Rate
The compounding frequency of the interest rate is the interest on a loan figured on the principal and accumulated interest. It is basically interest paid on interest.
Payment Amount
The payment amount is money due on a specific date as agreed upon in the loan contract.
When you grasp the refinancing components, you can draw together a sound strategy to get started toward refinancing.
Refinance Strategy
A great strategy begins with a great plan, and a great plan begins with knowledge. The Mortgage Reports suggest using six tips in forming your refinance strategy. They include shoring up your credit score, shopping for best rates, monitoring home equity, calculating if refinancing is worth it, understanding your property value, and negotiating rates and fees with lenders.
Strengthen your credit score
Taking steps to eliminate errors and wrong information from your credit scores is one way to enhance it. The Mortgage Report indicates that in a consumer survey of 6,000 people, over a third reported credit score errors, while 12 percent discovered errors that might harm their credit.
Your credit score is the first thing lenders will evaluate in the refinancing process. Harmful errors can be costly if not resolved before getting started.
Shop for best refinancing rates
Many homeowners go with the first quote they obtain, costing them more in interest rates than necessary. The Mortgage Reports notes that homeowners who shopped around for mortgage rates slashed their interest rate by half.
Be cautious with home equity
If you include closing costs in your loan amount, you may lose equity. However, it will return as you make payments, and the property value increases. Equity is the most important thing you own in a home, and you must protect it.
Strategize and plan how you cash-out and spend your equity very carefully. Some expenditures like home improvements, education, or business investments may be worth it, while short-term spending such as money spent on vacations is not.
Assess if refinancing is worth the effort
Refinancing a mortgage is best when rates are low. However, be aware that refinancing your home many times will cost you more money in the long run. You should also consider closing costs and fees and what they add to the equation.
To make the refinanced mortgage work best and save money, some homeowners will choose a shorter-term loan or make additional payments on the loan. It also helps them avoid an extension later down the road.
Evaluate your property value
Examine the real estate market in your area for comparable properties. This will help you get an idea of your rising equity and home value.
However, a professional appraisal from a trusted source is the best way to accurately know your property’s value. It will be worth the costs if you refinance because you must know this information before agreeing to a home refinance loan.
Negotiate rates and fees
Mortgage rates and fees change constantly. Homeowners don’t often realize that fees are also negotiable in addition to interest rates in a lot of instances.
Make sure you have the most current and up-to-date information before you negotiate with lenders. It is the only way to go into a refinancing transaction.
Another part of a good strategy is to thoughtfully and logically examine the advantages and disadvantages of refinancing. It just makes good sense.
Advantages and Disadvantages of Refinancing Your Home
Refinancing your mortgage comes with pros and cons that you need to consider carefully before making a final decision. Since everyone’s situation is different, each advantage and disadvantage will have a different meaning to every consumer.
Refinancing is a big decision, and you need to decide if it is worth taking the hit on your credit. Take the time to absorb all the information you can and make sure it is the right move for you.
CNBC presents a few advantages and disadvantages to reflect on before committing:
Advantages
- Lower interest rate
- Lower monthly payments
- Shorter payoff term
- Cash-out refinance to pay down debt
Disadvantages
- Closing costs
- Standard fees (title, survey, underwriter, legal, and many other fees)
- Additional fees (appraisal, credit, lender origination, admin, etc)
- Adverse effect on your credit score
- It could take a long time to close a refinance
Aside from the advantages and disadvantages of refinancing, you also need to evaluate how your debt-to-income ratio will factor into the loan and affect your credit rating.
Home Refinancing and Debt-to-Income Ratio
Your debt-to-income ratio (“DTI”) is the percentage calculated by the simple math formula of all your monthly debts divided by your gross monthly income. Lenders use it to determine if you are financially able to repay a loan.
The Consumer Financial Protection Bureau states that a 43 percent DTI is the cutoff point where most lenders consider a loan approval. Anything higher than that will not pass for a Qualified Mortgage.
Not only is the DTI the primary factor of obtaining a mortgage refinance loan, but it is also the most heavily weighted factor indirectly controlling your credit score. It impacts your credit significantly more than a hard credit check.
Your DTI doesn’t show up as a number on your credit reports because your income is not involved in formulating your credit score. However, the amount of debt does appear so that your DTI is easily calculated for lenders to review once they have the information. Be aware that debts represent 30 percent of your credit score.
As RefiAdvisor explains, there are two types of DTI ratio calculations. One is the front-end ratio, which uses your income with the mortgage you want to obtain. The other is the back-end ratio, which uses your income with the total of all your outstanding debt.
Positive steps you can take to improve your DTI and credit score is to pay off as much debt as you can before applying for more credit. Monitoring day-to-day spending and eliminating unnecessary expenditures are also simple things you can do that will positively impact your DTI and credit score.
If your DTI is no problem and you don’t mind how it affects your credit rating, you will still need to maintain a strong credit score during the refinancing process.
How to Maintain a Solid Credit Score in the Refinancing Process
You can do many things to secure a healthy credit score before and while you are in the refinancing process. The easiest way to think about it is that any significant changes to your income, stability, assets, credit, or debts may potentially be viewed as too much risk for a lender to accept.
NerdWallet recommends the following, even if you are preapproved for a loan:
- Don’t apply for new credit
- Don’t miss any payments
- Don’t make any big purchases
- Don’t switch jobs
- Don’t make large deposits over $1,000 without a paper trail
Anything can backfire until the loan is approved. Once your home refinancing loan is secured, you can make any changes you need.
Again, it cannot be understated how paying off as much debt as possible will be one of the most impactful moves in your planning. Even the smallest payoffs will add up to significant results.
Refinancing a mortgage is quite a process, but with careful planning, a strategy, and wise financial moves, it doesn’t have to impact your credit negatively.
Refinancing Your Home Doesn’t Have to Hurt Your Credit Score
Refinancing your home offers advantages worth considering, and it doesn’t have to hurt your credit score. Once you understand how credit works and what lenders are looking for, it becomes much easier to manage and apply for loans. If you found this article helpful, let us know below!
