When you’re paying off a car loan, you have the option of refinancing it—essentially, taking out a new loan to cover the old one. It makes sense to do this if your credit score has improved since you took out the original loan and you think you’ll be able to get better terms (such as a lower interest rate) on the new one.
This comes with obvious benefits, but it will slightly hurt your credit score. Read on to learn why this is, how much your score will drop, and whether this is something you really need to worry about.
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How will refinancing affect my credit?
Refinancing a car loan will cause your credit score to drop by several points—often by around 5–10, and sometimes by a little more. This hit to your score will be temporary. Your credit will probably recover within 6 months to 1 year.
A drop of this size isn’t meaningless, but it also isn’t something you need to be terribly concerned about. If you can save hundreds or thousands of dollars in interest by refinancing, it’s probably still worth it, despite the drop in your score.
However, if you’re thinking about applying for another credit account (such as a credit card or mortgage), it might be best to avoid doing it right after refinancing to give your score time to recover first.
Why refinancing a car hurts your credit score
Again, when you refinance your car (or any property you’re paying for with a loan), you’re paying off your old loan with a new one.
This will affect your credit score in three ways:
- Generating a hard inquiry: When you apply with your lender to refinance a loan, they’ll perform a hard inquiry (a type of credit check). This lets them assess (or reassess) your reliability as a borrower. Hard inquiries drop your credit score by several points, which is responsible for much of the damage that refinancing does to your score.
- Lowering your credit age: The length of your credit history contributes to your credit score. The older your credit accounts, the better. When you refinance your car, you’re adding a brand new loan to your credit report, which will lower the average age of your accounts and lower your score.
- Closing a credit account: Your original loan will be closed when you refinance. If you’ve already paid off a decent amount of it, this may slightly depress your score because many scoring models give you a small boost for having a loan that’s open but mostly paid off.
How long will the effects of refinancing an auto loan last?
Your credit score will mostly or fully recover from refinancing your car within 1 year. After that, you’ll have paid your new loan down somewhat, and it will have aged enough that it probably won’t be doing much damage anymore.
The effect of the hard inquiry will have faded as well. Hard inquiries stay on your credit report for 2 years, but they only affect your score for 1 year (and, in practice, they often have a negligible effect after around 6 months).
When is refinancing my car a good idea?
Even though it lowers your credit score, refinancing your car might still be a good idea if:
- Your credit score has improved: If you’ve taken steps to improve your credit score since you took out the original car loan, refinancing is probably worthwhile because you’ll be able to qualify for better terms and save money.
- Interest rates have dropped: Auto loan rates are affected by market conditions. If interest rates have dropped since you took out your loan, you might be able to get more favorable terms even if your credit hasn’t improved.
- You’re struggling with your monthly payments: If you apply for a loan with a longer term, your payments will be more spread out, which means you won’t have to pay as much each month. Note that unless your interest rate is lower, this may increase the total amount you end up paying for your car in the long term, but it will ease your monthly burden.
- You can handle higher monthly payments: Conversely, if your income is high enough, refinancing to a shorter-term loan can lower the amount you end up paying for your car in the long term.
Because the hit to your credit from refinancing is small (and temporary), it doesn’t need to be a major consideration when you decide whether or not to refinance your car. It’s more important to figure out whether doing so will actually save you a significant amount of money.
How to protect your credit score when you refinance your car
There’s no way to completely avoid the hit to your credit when you refinance, but if you’re careful, you can minimize the damage.
Take these steps to protect your credit:
Get prequalified
Prequalification doesn’t require a hard inquiry, so it won’t hurt your score, and it makes it easy to shop around. In other words, it gives you an idea of what kinds of loans you’ll be able to get.
When you eventually apply, you’ll still get a hard inquiry, but if you do your homework first by prequalifying, you can make it so that your first refinancing application is your last.
Apply in a short period
As mentioned, the credit scoring models “deduplicate” hard inquiries from credit applications that you make within the same short window (14 days for VantageScore, and 45 days for FICO).
To protect your score in every model, submit all your applications within a 14-day period so that your credit score only suffers from the effects of one hard inquiry.
Make all your payments on the new loan on time
It might seem obvious, but be very careful to manage your refinanced loan responsibly. Your payment history on your credit accounts is the single most important factor contributing to your credit score.
Making on-time payments on a loan is a good way to gradually build your credit score, but making even one late payment can undo all your progress and seriously damage your credit.
