Paying off debt is a goal worth striving for, especially if it can help improve your financial situation or free up money to spend elsewhere. But while it can help your budget, are there any downsides to paying off a loan? Will Prepaying a Loan Damage Your Credit?
It’s important to realize that paying off a loan early will not affect your credit score any differently than paying it off on time. But it’s true that paying off a loan can make your credit score better or worse, depending on your overall credit profile.
Even if there are short-term negative effects on your credit score, the benefits of paying off your debt can make the credit score worthwhile. 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 score
Your creditworthiness is made up of several different factors that are analyzed to give you and the lenders an overview of your overall creditworthiness. In some cases it is possible to see a decline in your credit rating after paying off a loan. However, this is not due to a conspiracy to keep you in debt.
Remember that credit scores are used to predict risk, specifically the risk of a potential borrower defaulting 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 closes the account. This causes a few things to happen:
- The payment history of the account is less influential. If you’ve always made your payments on time, that positive information will stay on your credit reports for 10 years. But for credit purposes, timely payments on an open credit account have a greater 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 important factor in a FICO credit score, so paying off debt in general can have a positive impact on your score.
- The loan no longer helps your long history. Your credit history length includes how long your credit accounts have been open and the average age of your accounts. When you repay a loan, FICO will still state the age of the account when it was closed, but it doesn’t seem to age with the rest of the open accounts.
- There are scoring models with less information to work with. Your credit score provides insight into how you have managed debt in the past and present. Once you’ve paid off a loan, there are no new data points from that account for loan 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 does my credit score drop after paying off a loan?
Because credit scoring models are so complex, it’s impossible to say exactly how prepaying a loan will affect your credit score. However, in general, practicing good credit habits helps.
Generally, when you look at the factors that go into your credit score, you will see less negative impact after paying off a loan if:
- They have a long credit history.
- You have always made your payments on time.
- It’s not your only installment loan.
- They have a good mix of different types of credit accounts.
Even though the decline is mainly due to the newly closed credit account, the effects are usually temporary and it is far more important to continue practicing good credit habits in order to build and maintain a high credit score.
“Paying off debt is the faster way to really improve your financial situation,” says Dean Kaplan, president of The Kaplan Group, a commercial debt collection agency. “This is more important than avoiding a small, temporary drop in a computer-generated credit rating.”
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 Pros and cons of paying off debt early and whether you can get more out of your money in another area of your financial life.
“Paying down debt means you have more money to invest and grow,” says Jay Zigmont, certified financial planner and founder of Childfree Wealth.
It can also reduce yours debt-to-income ratio, which can make it easier to approve a mortgage loan and other types of debt. Whether or not you need that cash flow for something else, it can bring you some peace of mind.
But here are some situations where paying off a debt faster might not make sense:
- The interest rate is low. if you have one mortgage At an interest rate of 3.5%, paying off this debt early results in a lot of extra cash flow that you can use for other financial goals. But if you put the extra money you’re considering investing in the retirement loan instead, you could end up with a long-term return of 7% or more, giving you more value than the potential interest savings from paying off the debt More quickly.
- You don’t have an emergency fund. It’s best to avoid accelerated debt payments if you don’t have enough savings to plan for financial emergencies. If you use all of your extra income to pay off your car loan and then the vehicle breaks down, you won’t be able to reclaim the extra payments from the lender to arrange the repairs.
- There is a prepayment penalty. Some loans may come with a Prepayment Penalty which is triggered if you repay the loan before a certain deadline. These penalties are not common, but you should always review your loan agreements carefully to make sure there are no surprises.
- They intend to borrow again soon. Paying off a loan can help reduce 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 expecting to borrow soon, you might not want to pay off a long-term account with an excellent credit history in full, as it will help improve your score,” says Kaplan.
In many cases, however, the impact on your credit score isn’t a big deal, especially in the long run. “If you see a slump after paying a debt, just shrug,” says Zigmont. “It’s not worth being in debt. Start focusing on yours net worth and use that as a measure of your progress.”
With all of this, it’s important 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 path that’s best for you to be determined in front.