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Dear Credible Money Coach,
I took out a personal bank loan for $20,000 for one year. If I pay it back early in the third or fourth month does this affect my credit score positively or negatively? — Mark D.
Hi Mark, and thanks for your question. First, I commend you for managing your finances so well that you’re in a position to pay off a significant loan amount early.
Any time you pay off a loan before the end of the term, you can save on the interest costs you would have paid if you waited the full term to pay off the loan. And who doesn’t want to save whenever possible?
But like almost every financial decision you can make, paying off a personal loan early has its pros and cons. To understand how prepaying a loan can affect your credit score, let’s start by looking at how credit scores work.
Factors that make up credit scores
Credit-scoring agencies use proprietary models to crunch the data from consumer credit reports and generate credit scores. Although your credit score can vary depending on the agency generating it, credit-scoring models generally consider the same basic factors (in this order of importance):
- Your payment history
- Total amounts you owe
- How long you’ve been using credit (your length of credit history)
- The mix of types of credit you have
- How many new credit applications or accounts you have
Lenders and credit bureaus look at those factors as indicators of how well you’ve managed credit in the past, and how you’re likely to manage new credit accounts. A long history of on-time credit payments, a lower amount of total debt and a good mix of credit types can contribute to a higher credit score.
How paying off a loan can affect credit scores
It is possible (but not definite) that your credit score could drop a bit immediately after you pay off a loan. That’s because paying off a debt affects some of those credit score factors we just discussed.
When you pay off a loan — whether you do it on time or early, as you’re considering — you reduce the mix of credit types you’re using. Credit-scoring models generally favor a mix, like credit cards, installment loans, mortgages, etc. A mix may indicate you’re good at managing different kinds of credit, rather than just one type.
Paying off the loan also reduces your total amount of available credit, which in turn affects your credit utilization ratio — the comparison of how much credit you use to how much total credit you have available.
If your objective behind paying off the loan early is to give yourself breathing room to take on a bigger, more significant debt like a mortgage, you may not want your credit score to drop right now. It might make more sense to put your money toward paying off any credit card or student loan debt you may have.
Why it still may be a good idea to pay off your loan early
Now, you may be thinking, "Bummer! Guess I’ll keep my loan." But despite the potential short-term effect on your credit score, there are some very good reasons to pay off your loan early.
I already mentioned one — interest savings. Paying off your loan just three months into your repayment term means you save nine months’ worth of interest. On a $20,000 loan, that amount could be significant, depending on your interest rate.
Then there’s the advantage of eliminating a monthly payment that’s likely north of $1,000. Imagine keeping that amount of money in your pocket for the rest of the year. What could you do with it? Pay down other higher-interest debt? Build an emergency fund? Increase your retirement savings?
Finally, there’s the psychological boost of paying off a debt. It’s a satisfying feeling. If avoiding a temporary hit to your credit score isn’t a priority right now, and you don’t need the money for anything else, go ahead and pay off your loan early.
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About the author: Laura Adams is a personal finance and small business expert, award-winning author, and host of Money Girl, a top-rated weekly audio podcast and blog. She’s frequently quoted in the national media, and millions of readers and listeners benefit from her practical financial advice. Laura’s mission is to empower consumers to live richer lives through her speaking, spokesperson, and advocacy work. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Follow her on LauraDAdams.com, Instagram, Facebook, Twitter, and LinkedIn.