How does refinancing affect credit score
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When your current mortgage no longer meets your needs, getting a different mortgage is desirable. However, getting a loan that big requires big collateral. The real estate the mortgage will be used for is the perfect collateral, however it is already pledged as collateral to the original mortgage. Refinancing is the process by which the existing loan on the real estate in question is paid off with the proceeds of the new loan which simultaneously acquires the real estate as collateral.
The biggest debt for many people is the mortgage on their house. Credit scores are based upon numerous factors in your credit history, including the types of loans and their amounts. Changing one of the largest of these accounts can make a big impact on the formula used to calculate a credit score.
Companies use credit scores for many purposes, including determining whether or not to issue credit to you and on what terms. In addition, many companies check your credit score to help determine things like insurance rates, whether or not to rent to you, and even in deciding whether or not to hire you.
How Credit Scores Are Calculated
Although the exact formula for calculating a credit score is a secret, a generalized explanation of the process has been published by Fair Issac, the company that provides the most widely used credit scores. The main elements that make up a person's credit score are Payment History, Amounts Owed, Length of Credit History, New Credit and Types of Credit Used.
Some of the elements are unaffected by refinancing. Both mortgages count as the same "type" of credit, so there no substantial change there. Likewise, unless the mortgage itself was the longest lived credit account, this element is not changed either. Payment history is, likewise, not substantially affected. While the old account counts as a paid-in-full creditor, the new account counts as a never-paid creditor. The remaining elements can be very much affected by a refinance.
credit score factors affected the most by a mortgage refinancing are Amounts Owed and New Credit. If the amount refinanced is equal to the original remaining mortgage amount, then the total amount owed overall does not change. However, there might be a small downward adjustment in your credit score because the new loan will now have a higher proportion of balance to loan amount. If you took out cash, resulting in a bigger loan, that would also cause your credit score to drop. Conversely, if you paid some of the principal with other funds, then the resulting smaller loan would cause the credit score to increase.
A new mortgage represents a very big adjustment to the New Credit factor. Even though there was a mortgage before, it was a different loan with a different creditor. This results in a small downward movement in credit score. However, this effect is typically short lived.
Although credit scores are based upon the current data reported in your credit report, many of the factors that go into calculating a credit score are calculated over a longer time period. For example, payment history is not just a function of whether or not accounts are current today, but rather what their status has been over several years. Likewise, formulas based on amounts owed and amounts remaining take into account more than a single day. As such, the effects on your credit score may occur over a period of time. Additionally, the negative effects of things like New Credit are lessened as the credit line ages.
Typically, the only real long-term effect of refinancing a mortgage comes from the amount of the new mortgage. Over time, the negative effects of having new credit fade away as a function of time. Other effects are eventually overcome by the positive effects of good payment history on both the new mortgage and other loans. The only lasting impact comes from either increasing or decreasing the total amount of debt by getting a larger or smaller loan.Source: ehow.com