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With the average consumer owing $16,748 in credit card debt, $28,948 in auto loans, and $180,018 in mortgage loans, according to the Federal Reserve, the burden of debt can be daunting.
Many consumers in debt only dream of paying off their loans early and how freeing it would feel to finally do so.
But what if paying off a loan early could hurt your credit? Would you be as inclined to speed up the repayment process?
We're constantly told to pay off debt as soon as possible but what potential downsides might we face?
A potential ding on your credit
Paying off credit card debt almost always increases your credit score because it widens the gap in your debt-to-income ratio. Paying off a loan, on the other hand, doesn't always offer that benefit. In fact, paying off a loan early can sometimes cause you to see a drop in your credit score.
That doesn't mean you should put off making payments toward the loan by any means, but there are factors to consider when going through the repayment process — especially when dealing with installment loans.
What are installment loans?
An installment loan refers to a lump sum that you borrow and repay in monthly installments until the loan amount is paid off. Your lender will report your payment history to the three major credit bureaus, Equifax, Experian, and Transunion. This could have a positive or negative impact on your credit score, depending on if you're keeping up with payments.
Common types of installment loans include:
- Personal loans
- Student loans
- Car loans
- Mortgage loans
- Home equity loans
How they differ from revolving loans
Revolving loans are lines of credit or credit cards that allow you to repeatedly access funds even after you've paid them off.
Credit cards are the most common type of revolving account, though a home equity line of credit could be a revolving debt if you repeatedly access the funds and pay it off like a credit card.
The primary difference is that once an installment loan is paid off, the loan account closes, and you're done with the money. Personal loans are a good example of installment loans. (If you think a personal loan might fit your needs, our list of the best personal loans is a great place to start.)
Revolving debt just lets you keep accessing money so long as you have money available, you continue to make payments, and the account remains open. As with an installment loan, your monthly payments will also show up on your credit report.
How paying off loans affects your credit
Does paying off an installment loan early affect your credit?
When most people ask how something affects their credit, they usually want to know how it's going to affect their credit score.
Your FICO credit score is a major factor that creditors look at when deciding if they'll lend you money, and it's generally broken down into the following:
Length of credit history
Types of credit
Insurance companies, banks, utility companies, and collection agencies might also check your credit score when making a decision, along with some entities that may come as a surprise.
When it comes to installment accounts, the areas we'll want to focus on the most are the amount owed, the average age of your credit history, and prepayment penalties.
- Amount owed: When you first pay off an installment loan, the "amount owed" goes down, which is good. But the account is now also closed, which reduces your available credit, and adjusts the type of credit you're using.
- Average age of your credit history: Keeping accounts in good standing for prolonged periods of time is a great way to increase your credit score over time. The problem, however, could be that your loan is tied to your oldest line of credit, meaning when you finally pay it off, the account will be closed and you might lose some length on your credit history. You can rebuild your score over time, and by maintaining a healthy mix of revolving debt and installment debt, but it's certainly worth having a heads up on the potential drop you'll see due to a closed account.
- Prepayment penalties: Depending on the type of loan you have, there might be a prepayment penalty for paying your loan off early. This fine-print factor is an important one to consider both when opening the loan and closing out the loan. Prepayment penalties should never keep you from making payments toward your debt, but could help determine whether or not to pay it off early or on a predetermined timeline.
Does paying off a car loan early hurt your credit?
The primary reason paying off your car loan early could potentially hurt your credit score is if the loan contributes to an unbalance in your active accounts of installment loans and revolving loans. Say, for example, your car loan is your only installment loan, you might see a dip in your score because the balance has shifted after paying off the loan.
Does paying off a mortgage early hurt your credit?
Paying off your mortgage early likely won't damage your credit, but it could end up costing you more than anticipated. In fact, many lenders do have a prepayment penalty clause built into their agreements that's worth asking about. This allows them to charge you a fee to help recoup some of the interest they would have earned had you kept your account open for longer. If you have specific mortgage questions, it's a good idea to reach out to your lender or loan servicer.
If you do make extra payments, make sure to tell your lender to apply those loan payments to the principal, not the interest rate.
If your mortgage is the only installment loan you have and you pay it off early, your score could drop by a few points, but it's nothing to be overly concerned about. Just as when you took out the loan, most mortgages and installment loans don't affect credit score when they're fully paid off. This is because installment loans are designed to be paid over time, so they are handled differently than revolving debt.
Does paying off student loans early hurt your credit?
There are pros and cons to paying off student loans early. If you've made regular, on-time, payments toward your student loan debt, your score likely won't drop. The biggest benefit is freeing up the extra cash you're paying toward your student loans and putting it toward another debt if you have one.
Another factor to consider is your interest rate. For example, if you owe $7,500 in student loan debt and your interest rate hovers around 2.8%, your annual interest would be nominal, around $250 per year, or about $20 per month, which wouldn't necessarily be a strong candidate for paying off early if you have other more important expenses.
However, if you have a larger loan with a higher interest rate, the total cost of the loan might be enough motivation for you to prioritize paying it off early. Paying off student loan debt early won't likely damage your score, but it won't help it much either.
If you have a larger student loan with a bigger interest rate, the total cost of the loan overall may be enough of a motivation for you to pay it off early. Paying off your debt early probably won't damage your score, but it won't help it either.
Is it better to pay off a loan early or on time?
Depending on your situation, it might be better to pay off your loan early. If you want to save money on interest, paying off your loan early to get out of debt can be a good way to improve your finances. However, it’s important to review your loan terms to ensure that you won’t incur any prepayment penalties if you do pay off a loan early.
Will your credit score drop when you pay off a loan?
In some cases, your credit score might be dinged if you pay off your loan early. Because you’re no longer building payment history on your credit report and there might be a change to your credit utilization or credit mix, you could see a relatively small drop in your FICO score.
Do you pay less interest if you pay off a loan early?
Generally, if you pay off your loan early, you’ll pay less interest because you’ll be making fewer interest payments over the life of the loan. The less time you’re paying interest on your loan, the more likely you are to save money.
What is a good debt-to-income ratio?
A good debt-to-income ratio depends on the lender and its guidelines. However, in general, if you have a debt-to-income ratio of 35% or less, you’re probably going to be viewed as a good credit risk. Check with your lender if you have specific questions about your debt-to-income ratio and how it could impact your ability to access loans or credit accounts.
The bottom line
Paying off an installment loan doesn't generally make credit scores drop dramatically. But there are a few ways it can impact your score.
For example, if your installment loan is the only installment loan you have, or it's your oldest account by several years, closing it could cause your score to drop since it impacts the length of your credit history.
The time it takes for your score to bounce back depends on the reason it dropped in the first place, but you could help improve your credit score by making on-time payments in full each month. Also, try not to close any credit card accounts, even if you're no longer using them. This will keep your credit aging.
Finally, patience is key. It won't happen overnight, but eventually, your score will get back to normal and you'll have less debt hanging over your head. In the meantime, practice skills like learning how to manage your money to put you in a better position for getting out of debt entirely.