A car loan may permit you to purchase a car, but that loan could have a few drawbacks. Some car loans have high-interest rates or large monthly payments. Consumers often refinance a car loan to reduce their payments. A refinanced loan is generally for a longer term than a current car loan and may also come with a lower interest rate. If you’re considering refinancing a car loan, it’s beneficial to understand how that refinance may affect your credit.
Understanding Credit Scores
The lowest FICO credit score you can have is 300. The highest is 850. A FICO credit score has five main components. Ten percent of your score is determined by the number of new credit inquiries on your report. Another 10 percent in the mix, or types, of credit found on your report. Fifteen percent is the length of your credit history. Thirty percent is the amount of debt you have. The largest component, 35 percent, represents how well you have or have not paid your bills.
Your current auto loan appears on your credit report. It’s considered an installment loan. With a refinance, the lender will pay off the current loan. Paying off debt, such as an installment loan, helps your score; however, your report will also reflect the refinanced loan, which is larger. Thirty percent of your score is tied to the amount of debt you have.
The larger loan will increase the amount of debt on your report, which might negatively affect your score and cause it to drop. According to FICO, how much a loan drops your score will depend on the other information in your particular credit report.
When you apply for an auto loan, the lender will pull your credit. When this happens, it places an inquiry on your credit report. Ten percent of your score is determined by the amount of new credit you’ve applied for. Multiple inquiries can lower your credit score.
FICO does make an exception for auto and mortgage loans, however. When you shop for an auto loan, you may seek multiple quotes from different lenders. This is called rate shopping. If those inquiries occur within a two-week time span, FICO will count them as a single inquiry. At most, a single inquiry may only drop your score by up to five points, according to FICO.
If your credit is affected by a refinance loan, that effect isn’t permanent. Your credit score is based on your credit report and as the information in the report changes, so does your credit. For installment loans, FICO looks at how much of the loan is still owed versus the amount of the original loan.
Paying down an installment loan shows you can manage and pay down debt, according to FICO, and this improves your score. Also, according to FICO, paying your bills promptly and reducing your overall debt will improve your score over time. These two areas make up the bulk of your credit score and can have the largest impact on it.