You've heard about all the practical reasons for refinancing your student loans: It can lower your monthly payment, lower your interest rate, and even help you pay off your debt sooner.
But how does refinancing affect your credit score?
Does refinancing your student loans hurt your credit score?
First, let's dispel with the negatives. There's only one, and it's small. Your credit will take a tiny hit initially due to credit inquiries — though you can minimize the impact if you limit your shopping around to 15 days.
The net effect of refinancing your student loans is generally positive. That's because it helps improve your financial health in general. But let's get more specific.
A lower monthly payment leads to a better debt-to-income ratio
Many student loan borrowers struggle with too-large monthly payments in proportion to their income. In other words, you may not have a lot of money left over after your bills and living expenses.
Borrowers in these situations have what's known as high debt-to-income ratio — when too much of your monthly income is going toward your debt obligations.
This isn't good for your financial health. Along with credit scores, lenders look to debt-to-income ratio to determine how risky it would be to lend to a borrower. A high debt-to-income ratio is a signal to lenders that you could have trouble making monthly payments. They may not choose to lend to you at all, or if they do, you could end up with a high interest rate.
If your student loans are contributing to a high debt-to-income ratio, refinancing can help. By lowering your monthly payment, you can lower your ratio and increase your credit worthiness.
Because your credit score is based on your payment history, along with other factors, having a more manageable monthly payment will make it easier for you to make on-time payments, thereby improving your score.
Paying off your loan faster will reduce your overall amount of debt
Many people refinance in order to pay off their student loan debt faster. Through refinancing, you may be able to get a lower interest rate. Over the long term, a lower interest rate will save you money and it will help you pay off your debt faster.
That's because monthly loan payments are applied in a very specific order:
- Any late fees you've incurred
- The interest you owe
- The principal loan balance
To pay off your debt, you need to eliminate the principal loan balance. Lowering your interest rate means more of your monthly loan payment goes toward your principal loan balance.
Ultimately, paying off your debt quicker can lead to a better credit score because you've shown that you have a history of making consistent payments toward your debt obligations. This shows your credit worthiness.
You might be thinking, but can't refinancing hurt your score, considering that you're taking on a new debt obligation? Not really. Because student loans are considered secured debt, they don't negatively impact your credit score the same way revolving or unsecured debt, like many credit cards, does. Secured debt is viewed more favorably by lenders; in fact, this kind of debt is often used as a way for people to build up their credit.
In other words, running up your credit cards to make or pay off your student loan payments will hurt your credit. But refinancing? It can actually help.