Paying off debt is a worthy goal, particularly if it can help improve your financial situation or free up money to spend in other areas. But while it may 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 off a loan early doesn’t impact your credit any differently than if you were to pay it off on time. But it’s true that paying off a loan can affect your credit score for better or for worse, depending on your credit profile overall.
Even if there is some short-term negative impact to your credit, the benefits of paying off your debt can make the credit hit worth it. Here’s what you need to know about what happens to your credit score when you pay off a loan.
[Read: Best Personal Loans.]
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’s possible to see a drop in your credit score after you’ve paid off a loan. This isn’t due to a conspiracy to keep you in debt, though.
Remember, credit scores are designed to predict risk, particularly the risk of a potential borrower defaulting on a debt. While credit scoring models are far from perfect, they’re 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 account’s payment history is less influential. If you always made your payments on time, that positive information will remain 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 the FICO credit score, so paying down debt, in general, can have a positive impact on your score.
— The loan no longer helps your 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 upon its closure, but it won’t grow older, 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’ve managed debt in the past and in the present. Once you pay off a loan, there are no new data points from that account for 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.
[Read: Best Credit Cards for Excellent Credit.]
How Much Will My Credit Score Drop After Paying 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, though, it helps to practice good credit behaviors.
Looking at the factors that go into your credit score, you’ll generally see less of a negative impact after paying off a loan if:
— You have a long credit history.
— You’ve always made your payments on time.
— It’s not your only installment loan.
— You have a good mix of different types of credit accounts.
Also, keep in mind that if your credit score does drop after you pay off a loan, it may not be due solely to your decision to pay off the debt. Review your credit reports for other potential causes, such as a higher credit utilization rate on your credit cards, a missed payment, recent credit inquiries or something else.
Even if the decline is primarily due to the newly closed loan account, the impact is usually temporary, and it’s far more important to continue practicing good credit habits to build and maintain a high credit score.
“Paying off debt is the faster way to truly improve your financial condition,” 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.”
[Read: Best Mortgage Lenders.]
Does It Make Sense to Pay Off a Loan Early?
Can you pay off a loan early? Absolutely, but it’s important to consider both the pros and cons of paying off debt early and whether 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, a certified financial planner and founder of Childfree Wealth.
It can also reduce your debt-to-income ratio, which can make it easier to get approved for a mortgage loan and other types of debt. Regardless of whether you need that cash flow for something else or not, it can provide some peace of mind.
But here are some situations where it might not make sense to pay off a debt faster:
— The interest rate is low. If you have a mortgage with a 3.5% interest rate, paying off that debt early will result in a lot of additional cash flow that you can put toward other financial goals. But if you invest the extra money you’re thinking about putting toward the loan for retirement instead, you could end up with a long-term return of 7% or more, giving you more value than the potential interest savings of paying off the debt faster.
— You don’t have an emergency fund. It’s best to avoid accelerating your debt payoff if you don’t have enough savings to plan for financial emergencies. After all, if you put all of your extra income toward paying off your auto loan and then the vehicle breaks down, you can’t request the extra payments back from the lender to take care of the repairs.
— There’s a prepayment penalty. Some loans may come with a prepayment penalty that triggers if you pay off the loan before a certain deadline. These penalties aren’t 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 reduce your debt-to-income ratio, but if it will also temporarily reduce your credit score, it could be worth keeping the loan if your DTI is low enough as-is. “If you are expecting to borrow soon, you might not want to completely pay off a long-term account that has a great credit history, as that helps boost your score,” says Kaplan.
In many cases, though, the impact on your credit score isn’t a huge deal, especially in the long term. “If you see a dip after paying a debt, just shrug it off,” says Zigmont. “Keeping debt around is not worth it. Start focusing on your net worth and use that 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 advantages and disadvantages of each option and determine the best path forward for you.
Reviewed on July 3, 2023:This article was published previously at an earlier date.
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