Paying off debt is a worthwhile goal, especially if it can help improve your financial situation or free up money to spend in other areas. But while it can help your budget, are there any downsides to paying off a loan? Does paying off a loan early hurt your credit?
It’s important to know that paying a loan early doesn’t affect your credit any differently than paying it off on time. But it’s true that paying off a loan can affect your credit score for better or worse, depending on your overall credit profile.
Even if there is some short-term negative impact on your credit, the benefits of paying down your debt can make it worth it. Here’s what you need to know about what happens to your credit score when you pay off a loan.
How paying off a loan affects your credit
Your credit score is made up of several different factors, which are analyzed to give you and lenders a snapshot of your overall credit health. In some cases, it is possible to see a drop in your credit score after paying off a loan. However, this is not due to a conspiracy to keep you in debt.
Remember, credit scores are designed to predict risk, particularly the risk that a potential borrower will default on a debt. While credit scoring models are far from perfect, they are still driven by consumer behavior.
In particular, when you pay off a loan, the lender will close the account. This causes a few things to happen:
- The payment history of the account is less influential. If you always made your payments on time, that positive information will stay on your credit reports for 10 years. But for credit scoring purposes, on-time payments on open credit accounts have more of an impact on your credit score than a positive payment history on a closed account.
- You have less debt. The amount of debt you owe is the second most influential factor in your FICO credit score, so paying down debt in general can have a positive impact on your score.
- The loan no longer helps its length of history. The length of your credit history includes how long your credit accounts have been open and the average age of your accounts. When you pay off a loan, FICO will still include the age of the account at the time it was closed, but it won’t age, so to speak, with the rest of your open accounts.
- It gives scoring models less information to work with. Your credit score provides a picture of how you have handled debt in the past and present. Once you pay off a loan, there are no new data points from that account for the credit scoring models to use in their calculations. In fact, FICO has stated that having installment loans with low balances relative to their original amounts is considered less risky than having no installment loans at all.
How much will my credit score drop after I pay off a loan?
Because credit scoring models are so complex, it’s impossible to say exactly how paying off a loan early will affect your credit score. In general, however, it helps to practice good credit behaviors.
When looking at the factors that go into your credit score, you’ll typically see less of a negative impact after paying off a loan if:
- You have a long credit history.
- You have always made your payments on time.
- It’s not your only installment loan.
- It has a good mix of different types of credit accounts.
Even if the decline is primarily due to the newly closed loan account, the impact is often temporary, and it’s much more important to continue practicing good credit habits to build and maintain a high credit score.
“Paying off debt is the fastest way to truly improve your financial situation,” says Dean Kaplan, president of The Kaplan Group, a commercial collection agency. “That’s more important than avoiding a small temporary drop in a computer-generated credit score.”
Does it make sense to pay off a loan early?
Can a loan be paid off early? Absolutely, but it is important to take into account both the Pros and cons of paying off debt early and if you can do more with your money in another area of your financial life.
“Paying off debt means you have more money to invest and grow,” says Jay Zigmont, certified financial planner and founder of Childfree Wealth.
You can also reduce your debt to income ratio, which can make it easier to get approved for a home loan and other types of debt. Regardless of whether or not you need that cash flow for something else, it can give you some peace of mind.
But here are some situations where it might not make sense to pay off debt faster:
- The interest rate is low. If you have a mortgage With an interest rate of 3.5%, paying off that debt early will result in a lot of extra cash flow that you can put toward other financial goals. But if you invest the extra money you plan to put into your retirement loan, you could end up with a long-term return of 7% or more, giving you more value than the potential interest savings from paying down debt. faster.
- You don’t have an emergency fund. It’s best to avoid rushing your debt payment if you don’t have enough savings to plan for financial emergencies. After all, if you spend all your extra income on your car loan payment and then the car breaks down, you can’t ask the lender to pay you back for the extra payments to take care of the repairs.
- There is a penalty for prepayment. Some loans may come with a prepayment penalty that is activated if you pay the loan before a certain term. These penalties are not common, but you should always review your loan agreements carefully to make sure there are no surprises.
- You plan to borrow again soon. Paying off a loan can help lower your debt-to-income ratio, but if it also temporarily lowers your credit score, it might be worth keeping the loan if your DTI is low enough as it is. “If you’re hoping to borrow soon, you may not want to pay off a long-term account that has excellent credit history, as that helps improve your score,” says Kaplan.
However, in many cases, the impact on your credit score is not a big deal, especially in the long run. “If you see a drop after paying off debt, just shrug it off,” Zigmont says. “Maintaining debt is not worth it. Start concentrating on your net worth and use it as a measure of your progress.”
In all of this, the important thing is that you take the time to consider the different ways you can use your money to improve your financial situation, research the pros and cons of each option, and determine the best path forward for you.