Christopher Liew: Thinking of refinancing your debt? The benefits, drawbacks, and credit impact

With interest rates still high and living costs squeezing household budgets, personal finance contributor Christopher Liew gives advice on whether refinancing or consolidating your debt could put you in a better position. (Getty Images / Hanizam)

Christopher Liew is a CFP®, CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers at Blueprint Financial.

With interest rates still high and living costs squeezing household budgets, many are wondering if refinancing or consolidating their debt could put them in a better position. By rolling multiple debts into one new loan, or refinancing a single high-interest debt, you can simplify payments and potentially lower interest costs.

It’s not always the right move for everyone, though. While refinancing can help your monthly budget, it can also come with hidden costs or long-term trade-offs.

Benefits of refinancing or consolidating debt

If you’re in a good financial position and have a good payment history, consolidating or refinancing debt can help relieve some of the pressure on your shoulders.

Lower interest rate

One of the major advantages of refinancing is the potential to reduce your current interest rate, especially if your credit score and payment history have improved since you first borrowed.

A lower rate means more of your payment goes toward the principal balance rather than interest, helping you pay off debt faster and costing you less money overall. This is particularly beneficial for those carrying high-interest credit card or auto loan debt.

Better repayment schedule

If you’re juggling due dates for multiple loans and contending with varying interest rates, consolidation can help streamline everything into one simple monthly payment.

This reduces the risk of missed payments, late fees, and the mental strain of managing multiple accounts, allowing you to stay consistent.

Can lower your credit utilization rate

Refinancing credit card debt could significantly improve your credit score.

Your total debt will remain the same since you’re essentially just transferring your credit card debt into a personal loan. However, your credit cards will then drop to a $0 balance, decreasing your credit utilization rate (which most professionals recommend leaving at less than 30 per cent).

Since your utilization rate is an important factor in your credit score, reducing it should boost your score in the following months.

Drawbacks of refinancing debt

While the benefits of refinancing or consolidating your debt are pretty easy to see, there are nuances that might not make it the best option for everybody.

Here are the potential drawbacks you should consider before making a decision.

Hard credit pull

For starters, applying to refinance your debt will result in a hard credit pull on your profile. While a hard pull will fall off of your profile after a couple of years, this could temporarily ding your credit score.

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This could be especially impactful if you’re in the process of applying for a mortgage. Most real estate agents and mortgage lenders recommend that prospective home buyers don’t apply for new lines of credit or initiate hard credit pulls until their home is closed on and their mortgage is finalized, as this could negatively impact the mortgage interest rate or result in a denial.

You could pay more interest

While refinancing and consolidation often go hand-in-hand with lower interest rates, they may also offer a longer loan repayment period to help lower your monthly payments. Depending on the refinancing terms, you could end up paying more in the long run, even with lower interest, due to the longer repayment period.

While this isn’t necessarily a dealbreaker, you may want to consider making larger monthly payments to reduce your loan term so you can take full advantage of the lower interest.

Potential penalties

Refinancing your loan could result in early repayment penalties. Some lenders impose penalties (which could be a flat fee or extra interest fees) if you pay off or refinance the loan before your repayment term ends.

Before applying to refinance, make sure you double-check with your current loan to make sure you won’t have to contend with penalties. While these penalties may not completely rule out your decision to refinance, you should also make sure that refinancing results in a net win for you rather than a net loss.

You’ll need to have good credit

If you made some credit mistakes in the past, like missing payments or maxing out your cards, you may have some trouble getting qualified to refinance or consolidate your debt. Before refinancing, it’s a good idea to check your free credit report as well as your score.

Generally, lenders will want to see a score in the high 500s or low 600s before approving you to refinance. Even with a decent score, if you have recently missed payments, it might be a good idea to build up six to 12 months of on-time payment history before applying to refinance your loan. Otherwise, you could receive a hard pull on your credit profile for nothing.

You need to prove steady employment

To get approved for refinancing or consolidating your debt, you’ll need to prove that you’ve been steadily employed and can cover the cost of your payments. If you’re self-employed, you’ll typically need to show two year’s worth of tax returns to prove income.

If you’ve been between jobs, work part-time, or just started a business, you may not get approved.

Debt can rack up again

When talking about consolidating credit card debt, one of the most dangerous things that can happen is that you’ll start racking up credit card debt again once your cards are paid off.

If you don’t have the financial discipline to not use your cards (or at least use them wisely), then you could end up in a worse position with your cards maxed out and an entirely separate loan to pay off.

Final thoughts

Generally speaking, refinancing or consolidating your debt is a great way to lower your interest payments, build a better repayment structure, and simplify your loans.

Before applying to refinance, though, make sure you have a good idea of where your credit and personal finances stand, as well as any potential early repayment penalties.

This will help you determine if you have a good chance of getting approved or if you need to work on your credit more before applying.

More from Christopher Liew:

• The smart way to pay off debt without feeling deprived
• Renting versus owning: benefits and drawbacks of each
• What are the pros and cons of a reverse mortgage?
• My favourite personal finance hacks