Paying off your debts is a worthy goal, especially if it can help you 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 prepaying a loan hurt your credit?
It’s important to know that paying off a loan early doesn’t affect your credit any differently than paying it back 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 a short-term negative impact on your credit, the benefits of paying off your debt can be 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 insight into your overall credit health. In some cases, it is possible to see a drop in your credit score after repaying a loan. It’s not due to a conspiracy to keep you in debt.
Remember that credit scores are designed to predict risk, specifically the risk that a potential borrower will not repay a debt. Although credit scoring models are far from perfect, they still depend on consumer behavior.
In particular, when you repay a loan, the lender closes the account. This causes several things:
- The payment history of the account has less influence. If you have always made your payments on time, this positive information will remain on your credit reports for 10 years. But for credit scoring purposes, timely 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 FICO credit score, so paying down debt, in general, can have a positive impact on your score.
- The loan no longer helps your story length. 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 when it was closed, but it won’t age, so to speak, with the rest of your open accounts.
- This gives the scoring models less information to work with. Your credit score gives a picture of how you have managed your debts in the past and in the present. Once you have repaid a loan, there are no new data points from that account for the credit score models to use in their calculations. In fact, FICO said 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 paying off a loan?
Because credit reporting models are so complex, it’s impossible to say exactly how prepaying a loan will affect your credit score. In general, however, it helps to practice good credit behaviors.
By 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 have always made your payments on time.
- It’s not your only installment loan.
- You have a good mix of different types of credit accounts.
Even though the decline is mainly due to the newly closed loan account, the impact is usually temporary and continuing to build good credit habits is much more important to establishing and maintaining 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.”
Is it wise to repay a loan early?
Can a loan be repaid early? Absolutely, but it is important to consider both the pros and cons of early debt repayment and if you can do more with 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 your debt to income ratio, which can make it easier to get approved for a mortgage and other types of debt. Whether or not you need that cash flow for something else, it can give you some peace of mind.
But here are a few situations where it might not make sense to pay off a debt faster:
- The interest rate is low. If you have a mortgage at a 3.5% interest rate, paying off that debt early will generate plenty of extra cash flow that you can spend on other financial goals. But if you instead invest the extra money you plan to invest in the loan for retirement, you could end up with a long-term return of 7% or more, which will give you more value than the savings of potential interest on debt repayment. faster.
- You don’t have an emergency fund. It’s best to avoid rushing your debt repayments if you don’t have enough savings to prepare for financial emergencies. After all, if you’re spending all of your extra income paying off your car loan and the vehicle breaks down, you can’t ask the lender to pay back the extra payments to take care of 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.
- You plan to borrow again soon. Paying off a loan can help lower your debt-to-equity 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 planning to borrow soon, you might not want to completely pay off a long-term account that has a good credit history, because that helps boost your score,” Kaplan says.
In many cases, however, the impact on your credit score isn’t huge, especially in the long run. “If you see a drop after paying off a debt, just ignore it,” Zigmont says. “Keeping up debt isn’t worth it. Start focusing on your net value 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 for you. .