Refinancing a car loan could get you better loan terms and free up funds in your budget. But how will it affect your credit score?

The reality is you’ll likely see a small drop in your credit score. But don’t steer clear of refinancing just because of a temporarily lowered score. It could be a sound decision that results in cost savings or much-needed financial relief.

How refinancing a car loan affects credit

Refinance a car loan can impact your credit profile. This is due to your FICO credit score, which is a credit score provided by the Fair Isaac Corporation. FICO scores are based on how you manage your credit, including your payment history, how much debt you owe, the length of your credit history, and even any recent credit applications — such as applications to refinance your car loan.

This credit scoring model may lower your score a few points when you apply for new credit and a hard inquiry is placed on your credit report. In addition, a new account on your credit profile decreases the average age of your credit accounts, which also impacts your overall FICO score.Here is a deeper look at how refinancing a car loan impacts your credit:

  • It generates hard inquiries: Each time you apply for a loan, a hard credit inquiry is generated, which could result in a slight dip in your credit score. Hard inquiries remain on your credit report for up to two years but only impact your score for up to 12 months. Consequently, refinancing a car loan — which involves applying for a new loan — could temporarily ding your credit score.
  • It lowers your accounts’ average age: Refinancing also lowers your average age of accounts, leading to a possible decrease in your credit score. The good news is account age only counts for 15 percent of your credit score. Your score should bounce back quickly if you responsibly manage your new auto loan and other debt accounts.
  • It has more impact if reported as a new loan: If your loan refinance is reported as a “new” loan, it will more significantly impact your credit profile. The refinance will not only generate a credit inquiry but also have the added impact of creating a new “open date” on your profile. When a new open date shows up, it tells the credit agencies you have taken on a new debt obligation, increasing your overall debt load.

How to limit harm to your credit score

Although your credit score may drop when you refinance, there are ways to minimize the impact:

  • Get prequalified. Shop around to find the best deal on refinancing. Once you have a shortlist of preferred lenders, get prequalified to view potential financing offers without affecting your credit score.
  • Apply within a certain window. If you submit loan applications within a 14-day timeframe, most credit scoring models will group them into a single inquiry. This is referred to as rate shopping and can also minimize the impact on your credit score.
  • Make timely auto loan payments. The most significant component of your credit score is your payment history. It accounts for 35 percent, so paying your loan on time each month will help your credit score bounce back.
  • Wait to open additional credit accounts. Your credit age will decrease when you refinance. Holding off on opening new credit accounts after refinancing will help improve this number and possibly raise your credit score over time.

How refinancing a car loan works

When you are ready to refinance your auto loan, follow these steps to make the process more seamless:

  1. Check your credit. Review your credit report to ensure it’s free of errors, and file disputes to resolve any issues you find. Taking this step can help improve your credit score. A higher score — 670 or above — improves your odds of securing a new loan with attractive terms.
  2. Find the best loan offers. There is no shortage of auto loan refinance options, so you will need to shop around to find the best deal. Read lender reviews and get prequalified to view loan offers you may qualify for.
  3. Submit a formal application. Most banks, credit unions and online lenders feature simple online applications. You can also visit a branch or call in to apply. You may receive a lending decision immediately, but the financial institution may take a bit to finalize the closing documents.
  4. Seal the deal. Review the loan documents and address any questions or concerns with the lender. After you sign, the new lender will provide you with a check to pay off your current loan or handle the transaction itself.

When to refinance your car loan

There are several reasons why refinancing your auto loan could make sense. However, you should only move forward when the time is right.

If auto loan rates have dropped since you took out your car loan or your credit score has improved, and you can now qualify for a better rate, refinancing is worth considering.

Refinancing is also sensible if you’re going through a rough financial patch and need lower car payments to free up cash. Even if you receive the same interest rate, you may be able to extend the loan term, which lowers your monthly payment.

You could seek a car loan modification, rather than refinancing, which involves adjusting the monthly payment amount, due date or interest rate on your existing loan.

You should also refinance if you need to add or remove a co-borrower to the loan.

The bottom line

There are pros and cons to refinancing your car loan. It can temporarily hurt your credit score. However, the financial benefits may significantly outweigh a drop in credit rating. There are also ways to minimize the impact on your credit score and help it rebound when you apply for refinancing.

Before deciding if refinancing makes sense, familiarize yourself with the process to avoid any surprises. Also, explore lenders, get prequalified and run the numbers to make an informed decision.