One of the largest factors when it comes to determining your credit score is whether you pay off your debts on time. If you have a history of paying off debts in full and on time, you’ll likely have a better credit score than someone who frequently makes late payments. Thus, you would think that paying off a loan would automatically improve your credit score—however, the reality is more complicated than that.
Paying off a loan can indeed improve your credit score. But, at the same time, paying off a loan may not immediately improve your credit score. In some cases, paying off a loan can even hurt your credit score in the short-term. Whether paying off a loan helps or hurts your credit score depends on a variety of factors.
This may sound confusing, but don’t worry—we’ll unpack it all and explain the reasons why your credit score may increase or decrease when you pay off a loan. Read on to learn more about how much a loan affects your credit score or use the links below to navigate to any section in the article.
- How Does Paying Off a Loan Affect My Credit?
- Credit Cards vs Installment Loans
- How Credit History Affects Your Credit Score
- Paying Off Different Types of Loans
- Should I Pay Off My Loan Early?
- How Can I Manage My Credit?
- Reduce Your Debt While Maintaining a Healthy Credit Score
How Does Paying Off a Loan Affect My Credit?
Paying off a loan can potentially have a positive or negative effect on your credit in the short-term. Whether paying off a loan affects your credit in a positive or negative way depends in large part on the type of credit you have and your current financial situation. Factors such as your credit mix, loan payment history, account balances, and total debt all have an impact on how your credit is affected when you pay off a loan. We’ll go into more detail on that shortly.
In any case, paying off a loan is generally good for your finances. By getting rid of the loan, you take a financial burden off your shoulders, stop racking up interest charges, and increase your level of financial flexibility. Plus, you will lower your total debt, which can improve your credit score in the long run.
Does Paying Off a Loan Early Hurt Your Credit?
When you pay off a loan, it’s possible for your credit score to briefly drop. While it may seem counterintuitive, there are a few reasons this happens. Paying off a loan early can hurt your credit if:
- It was the sole loan under your name. Getting rid of the only loan under your name eliminates any current loans from your credit report. This, in turn, can hurt your credit mix, which makes up 10% of your FICO score.
- It’s an older loan. The length of your credit history makes up 15% of your FICO score. The longer your credit history is, the better. Paying off an older loan can reduce the average age of your accounts and thereby hurt your credit score.
- You have other loans with high balances. Since amounts owed makes up 30% of your FICO score, using too much of your available credit can have a negative impact on your credit score. If you pay off one relatively low balance loan but still have other loans with high balances, this may increase the amount of credit you’re using and hurt your credit score.
Credit Cards vs Installment Loans
Revolving credit is what you get when you are approved for a credit card. With a revolving account, you can borrow money each month up to a predetermined limit. And, when you pay the loan balance off, the account doesn’t disappear. In terms of your credit score, maintaining a very low balance on a credit card with a high credit limit will typically result in a higher credit score.
Installment loans are a bit different than revolving credit. With an installment loan, you have to make a set amount of payments over a certain period of time. Once you’ve made your final payment and the loan balance drops to $0, the account is closed. Examples of installment loans include mortgages and auto loans.
These two types of credit affect your credit score differently. With revolving credit, it’s important to keep your credit utilization low—or, in other words, don’t use up too much of your credit limit. Credit utilization will generally have a greater impact on your credit score than the debt you owe on an individual installment account. However, making timely and regular payments on your installment loan can also improve your credit score over time.
How Credit History Affects Your Credit Score
As we mentioned above, length of credit history accounts for 15% of your FICO score. If you’ve had accounts open for a long time, this will contribute to a favorable credit score. Even after the account is closed, FICO and other credit scoring models take into consideration the type of account it was and how long you had it for.
However, closed accounts are excluded from your credit report after a certain amount of time. Closed accounts that recorded late payments will stay on your credit report for seven years, while accounts in good standing can stay on your credit report for up to ten years.
Paying Off Different Types of Loans
Different types of loan present unique advantages as far as your credit score goes. Below, we provide you with a list of common loans and describe how much a particular loan affects your credit score.
Paying Off Student Loans Early
Paying off a student loan early shouldn’t have any negative impact on your credit score. Student loans don’t come with prepayment penalties, so you’re free to pay them off as fast as you’d like. At the same time, though, making consistent payments over the life of the loan can improve your payment history, which is the biggest factor in your FICO score.
Paying Off a Mortgage Loan Early
Many mortgages come with a prepayment penalty. This means that you will be charged a fee by the lender if you pay off your mortgage loan early. If you’re interested in making early payments on your mortgage, speak with your lender or review your mortgage agreement. If you’re able to make early payments, make sure you pay towards the principal balance of the loan rather than the interest.
Paying Off a Car Loan Early
Some car loans come with prepayment penalties because lenders want to maximize the amount of money they can make off interest. If your car loan doesn’t have a prepayment penalty, you might consider adding a little extra cash to each car payment to avoid paying interest over the long-term. However, keep in mind that if you pay off a car loan early and close the account, this can negatively impact your credit mix by reducing the diversity of your open accounts.
Paying Off a Personal Loan Early
Paying off a personal loan early is similar to paying off a car loan early. It may have a prepayment penalty so that the lender can earn as much interest as possible. And, while closing the account early may ease a financial burden, it can negatively affect your credit in some cases. A personal loan adds to the diversity of your open accounts, so closing it can negatively impact the credit mix category of your FICO score.
Should I Pay Off My Loan Early?
Whether or not you should pay off your loan early depends on a variety of factors. The right decision varies according to your financial needs and personal finance goals. Here, we’ll list some of the pros and cons
Pros of Paying Off a Loan Early
The pros of paying off a loan early include:
- One less payment to worry about each month: If you’re currently under financial stress or are saving for something big, cutting out a monthly payment can help you lower stress and achieve your goals.
- Save money on interest: Paying off a loan early can help you avoid paying interest in the long-term. However, look into whether a loan has a prepayment penalty to determine if the money you’re saving from interest is worth the penalty.
- An exciting step towards paying off debt: Nobody likes to be in debt. If eliminating debt is a bigger priority than your credit score, then paying off a loan early can feel extremely liberating.
Cons of Paying Off a Loan Early
The cons of paying off a loan early include:
- Could potentially lower your credit score: Paying off a loan early and closing the account can hurt your credit score in the short-term, so make sure to be strategic when it comes to how you go about it.
- Some types of loans have penalties for paying off early: Prepayment penalties are a common feature with loans like mortgages. Speak with your lender before paying off a loan early to find out whether you’d have to deal with any fees.
- Less money to put towards investments and savings like retirement: Paying off a loan early will require more money upfront, leaving you with less money for things like an emergency fund or retirement account. Weigh the risk before you pay off a loan early.
How Can I Manage My Credit?
Managing your credit doesn’t have to be difficult. Whether you want to improve your credit score to get a personal loan or to make finding an apartment easier, here are a few tips for building credit:
- Make on-time payments: Payment history is the most significant category in the FICO model, making up 35% of your credit score. Consistently making payments on time will improve your payment history, while falling behind on payments will hurt your credit.
- Pay more than the minimum balance when possible: Ideally, you should bring your credit cards to a zero balance every month. This can positively impact the amounts owed category of your FICO score and help you avoid interest payments.
- Use credit cards regularly: Using credit cards is a good thing as long as you don’t get carried away. Try to make small purchases on your credit card in order to keep your credit utilization low. This will also make it easier to pay off your bill at the end of each month.
Managing your credit may take some time and attention, but in the end it’s worth it. The Mint app makes tracking your finances and managing your credit simple. You can get a free credit score report no matter where you are or use our loan repayment calculator to come up with a long-term plan for paying off your loans.
Reduce Your Debt While Maintaining a Healthy Credit Score
Paying off a loan can affect your credit in different ways. Closing the account can have a positive or negative impact on your credit—or, in some cases, it won’t have any effect at all. In the end, you have to consider your own financial situation and goals to decide what choice is best for you.
However, one thing’s for sure: making timely payments and managing your debt can go a long way towards improving your credit score. Download the Mint app to track your credit card spending, set personal finance goals, and stay on top of your credit. With the right tools, patience, and a little effort, you can improve your financial well-being.