Refinancing student loans is like leveling up your finances. It lets you cash in on the progress you’ve made with your credit score, income, and other debts and lock in a better interest rate or more favorable terms.
But while an impressive credit score can help you secure a student loan refinance, refinancing can actually lower that score. Let’s take a look at why this happens, whether or not the sacrifice is worth it, and how you can limit the impact refinancing has on your credit score.
In this article:
- How refinancing student loans impacts your credit score
- How to limit the impact refinancing has on your credit
- Does the credit impact of refinancing benefit you in the long term?
- When refinancing student loans may hurt you
How refinancing student loans impacts your credit score
When you refinance a student loan, the lender will run a hard inquiry on your credit report. Each hard inquiry can cause up to a five-point drop in your credit score, impacting your score for about one year.
When you complete a refinance, the old loan will be closed, and a new loan will appear on your credit report. This will affect the average age of your credit accounts, which constitutes 15% of your credit score.
We’ll explain this further below.
Hard credit check
Lenders use information from your credit report, like if you pay bills on time and how much credit you’re currently using, to decide if you meet their lending criteria and how responsible you are as a borrower. The interest rate and terms they offer are also determined by what they see on your credit report.
During a hard credit check, or credit inquiry, a lender requests a copy of your credit report from a credit bureau to determine if you’re a good candidate for a loan.
The credit bureaus then mark the request on your credit report. Hard inquiries show that you’re looking for a loan, and each hard inquiry can cause your credit score to decrease by up to five points.
Multiple hard inquiries in a short period of time can signify that you’re relying too heavily on credit to fund your lifestyle. According to Rod Griffin, senior director of public education and advocacy for Experian, there is no shopping around for student loans.
“Instead, ask if you can get prequalified so it’s only a soft inquiry,” Griffin said.
Closure of existing loans
When you refinance a student loan, your old loan will be closed, and a new loan will open in its place. Griffin said closing old accounts can cause a minor ding in your credit score, but this will go away over time.
Opening of a new loan
The age of all your credit accounts is compiled into the average age, which makes up 15% of your credit score. The older the average age, the better your credit score. Lenders like to see a long credit history because it shows that you can be a responsible borrower over an extended period of time.
Also, any time you open a new account, you have to prove that you can make payments on time every month. Once you’ve done this for a few months, the credit bureaus will see that you are a responsible borrower.
The largest component of your credit score is caused by your payment history. The best way to maintain a good credit score is to always pay your bills on time.
How to limit the impact that refinancing student loans has on your credit
In general, refinancing can mean saving hundreds or even thousands in total interest over the life of a loan. Even if your credit score takes a dive, it will usually bounce back quickly. You can minimize the effect of refinancing on your credit report while still reaping the full rewards of refinancing.
1) Prequalify before submitting a full application
Before you complete a loan application, you should prequalify with different lenders. Prequalifying means that lenders won’t run a full credit check and instead compile just enough information to give you an interest rate estimate. Prequalifying only counts as a soft credit check and won’t impact your credit score.
These inquiries may appear on your credit report, but credit bureaus do not include soft inquiries when calculating your credit score. After you’re prequalified, choose the lenders with the best terms and apply with them to receive a final offer.
>> Read More: Best student loan refinance companies
2) Make sure you can meet your repayment obligations on the new refinance loan
When you’re choosing to refinance student loans, compare the different repayment terms carefully. Most lenders offer terms ranging from five to 20 years, with lower interest rates for shorter terms and higher rates for longer terms. Choose the monthly payment you can comfortably afford.
3) Continue repaying your existing student loans until the refinance is complete
Refinancing can take a few weeks to be processed, depending on the lender. In the meantime, keep making payments with your current lender. Missing a payment can have a huge impact on your credit score.
Once the refinance has been completed, note the new due date on your calendar. If possible, set up automatic payments to ensure that you don’t miss a payment on your new loan. Most student loan servicers provide a 0.25% interest rate discount when you sign up for autopay, so you’ll save some money.
Does the credit impact of refinancing benefit you in the long run?
You don’t need a perfect credit score to access the best interest rates and loan terms. You should also expect your credit score to fluctuate over time. However, if you pay on time and keep your overall credit use low, your score will remain high.
If you plan to apply for a mortgage at some point, refinancing your student loans could increase the amount you qualify for.
Here’s how it works:
When a mortgage lender calculates how much to approve you for, they’ll look at your debt-to-income (DTI) ratio.
The DTI ratio is the total monthly debt payments divided by your monthly gross income. For example, let’s say you have a $400 monthly student loan payment, and your annual gross income is $45,000. In this example, your current DTI is 10.67%.
Generally, the maximum DTI that a lender allows is 45%, which includes your future mortgage payments. In this case, the maximum monthly mortgage payment would be $1,287.50.
However, if you refinance the student loan to a new monthly payment of $325, you could have a maximum mortgage payment of $1,362.50.
When refinancing your student loans may hurt you
In some cases, refinancing your student loans could cost you more money and end up harming you financially.
Read below to learn when you should avoid refinancing.
If you’re taking out a mortgage or personal loan
If you’re about to apply for a mortgage or personal loan, you should avoid doing anything that will affect your credit score, such as refinancing your student loans. Refinancing can cause a slight drop in your score, and that drop could result in you receiving a higher interest rate on the new loan.
While this may have a small impact if you’re taking out a personal or auto loan, it can have a much bigger effect if you’re taking out a large loan like a mortgage. Griffin says you should wait three to 12 months after refinancing your student loans to apply for a mortgage. This will provide ample time for your credit score to bounce back to where it was before.
If you’re interested in taking out a mortgage now, wait until after you’ve closed on the home to refinance your student loans.
That being said, there are exceptions. If you have an excellent credit score and refinance your student loans, the impact may be small enough that delaying taking out a mortgage is unnecessary. Make sure to check your credit score after refinancing to see whether or not you should wait a few months before applying for a mortgage.
If you need access to federal student loan protections
If you refinance your federal loans, they will become private loans. Federal student loans come with certain benefits which don’t exist with private student loans. If you decide to refinance these loans, then you will lose access to the benefits listed below with no way to undo the decision.
Here are some benefits that you give up by refinancing your federal student loans:
- Income-driven repayment plans: Your payments will be based on your income and family size. If you stick with an income-driven repayment plan for 20 or 25 years, you may have the rest of your loan balance forgiven.
- Loan forgiveness programs: The federal government offers loan forgiveness programs only available for federal loans. The Public Service Loan Forgiveness (PSLF) program offers loan forgiveness to borrowers after 10 years of making payments and working for a qualifying nonprofit or government organization. If you are a teacher, social worker, or healthcare worker, you may qualify for PSLF.
- More deferment and forbearance options: Federal student loans provide more deferment options, including deferred interest for some borrowers. For example, the federal government suspended interest on student loans when the COVID-19 pandemic started, and private lenders generally offered six to 12 months of deferment with interest still accruing. If you lose your job, the deferment and forbearance options of your federal loans might make a big difference for your financial health.
If you’ve used any of these benefits in the past or it’s possible you may use them in the future, you will want to avoid refinancing. And if you’re eligible for loan forgiveness, you may save more by sticking with your federal loans.
>> Read More: Should you refinance your student loans?