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Does Early Loan Payment Hurt Your Credit Score?

Will Paying Off a Loan Early Hurt My Credit Score?

There are all sorts of different loans out there that are intended for a number of different uses. If you’re buying a home, you might need to take out a mortgage. If you’re buying a car, maybe you need an auto loan. If you’re facing an unexpected emergency expense and don’t have the savings to cover it, you might consider applying for a personal loan to help you handle the expense.

But regardless of what kind of loan you take out, you always need to remember to keep up with your payments to pay off your debt in a timely manner. With this in mind, you might be thinking that if you have the opportunity to pay off your loan early, you should go for it, right? Well, that may not always be the smartest move. There are some instances where paying off a loan earlier than scheduled won’t actually help certain aspects of your financial profile, like your credit score.

Does paying off a loan early hurt your credit? We’ll investigate this question and take a more detailed look at how paying off a loan early can affect your credit score.

Types of Credit and Your Credit Score

Vector image of a person holding a clipboard with credit score spectrum

A credit score is a three-digit number that’s meant to represent the likelihood that you’ll be able to pay your bills in a timely manner amongst other factors. It’s an important component of what many financial institutions use to assess the risk of lending you money. They’re dynamic numbers that are made up of a number of different components, like your payment history, the amount of debt you currently owe, the length of your credit history, and more. One of the most common scoring models, FICO, looks at some of the above-mentioned components along with others.

Different types of credit can contribute to making up your credit profile, and these different accounts can have an impact on your score. For example, if your payments (or non-payments) are being reported to a credit bureau, missing payments on installment loans or your credit card payments can negatively affect your score. On the flip side, making these payments in a timely manner may help you work towards increasing your credit score.

There are a few factors that contribute to your overall credit score, including your payment history, utilization rate, and types of credit. A score of 630 or higher is often when more borrowing options might start to open up.

FICO scoring model factors
FICO scoring model factors. Image via Credit Sesame.

Does Paying Off a Loan Early Hurt Your Credit Score?

As we mentioned earlier, there are instances where paying off a loan early won’t help your credit score. This is sometimes the case with installment loans.

With an installment loan, you’ll be given a lump sum and then you will pay back the amount you borrowed, plus interest and/or fees, over the course of a pre-determined number of scheduled payments. This account will then close when you’ve paid off the entirety of your balance. While paying off a loan early may not damage your score – although some lenders will charge a prepayment penalty for early payments – it won’t necessarily be maximizing the positive effect that an installment loan could potentially have on your credit.

Because your payment history is the most significant part of your credit score – for both the FICO model as well as the VantageScore model (the two most widely used scoring models) – having your loan open for it’s entire term and making all of your scheduled payments can send a positive signal to the scoring models and have a positive effect on your score. This is just one of a number of credit score best practices to keep in mind.

However, that doesn’t mean that it’s always a good idea to keep your loan open for as long as possible. You’ll need to take a look at what your financial goals are and assess what the best move is for you personally. For example, if you’ve been under a mountain of debt and finally have the means to pay a good chunk of it off, you may want to pay back more than you’re required to on a particular loan as long as you won’t be penalized for it.

When Should You Consider Paying Off Your Loan Early?

While there may be times where it might make sense to avoid paying a loan off early, there are also some instances where you could benefit from early repayment.

For example, you may be in a situation where you’re paying off a loan with particularly high interest rates. While you might be managing to make all your payments on time, the high interest you’re paying could be squeezing your bank account a little tighter than you’d like.

In this instance, it might be a good idea to pay off your short term loans as early as possible if you have the funds and won’t be penalized by the lender. This way, you can avoid having to continue to pay these high interest rates.

Another instance where you might want to pay off your loan early is when it comes to revolving credit. With revolving credit accounts like credit cards and lines of credit, you can keep a balance on your account from month to month as long as you’re making the minimum payments on time. Even if you end up paying off your entire balance, the account will still remain open. If you can keep your balance at zero (or very low), this could positively affect your credit score – particularly if these accounts have high credit limits. This is because of the importance of the amounts owed portion of your credit score.

When Should You Keep Your Loan?

There some instances where keeping a loan open may be a good idea. As an example, let’s look at why this may be the case with a car loan.

Man signing car insurance document or lease paper

If you have a bad credit score and you’re looking for ways to improve it, or if you don’t have much of a credit history in the first place, keeping your car loan open may be more beneficial to you than paying it off early. For example, let’s say that you don’t have very many credit accounts open in the first place. Keeping this account open and making all the scheduled payments on time could help you to build up your credit history. Having this type of loan open could also help you to diversify your credit portfolio and keep different types of credit accounts open, which is another factor that contributes to your credit score.

Paying off your car loan could even hurt your credit score if you’ve been keeping a low balance on it and your other credit accounts currently have a high balance. If you pay off your car loan and close the account, suddenly your available credit shrinks while the percentage of how much of your available credit you’re using (your credit utilization rate) increases. This could have a negative impact on the amounts owed portion of your credit score. In this scenario, you may want to consider paying off the loans with a high balance first before you pay off your car loan.

It’s also important to remember that you’ll only be able to reap the potential benefits of keeping your accounts open if you’re able to make the payments on all your debt on time. Make sure that you’re on top of all of your payment schedules and incorporate these into your regular budget.

Consequences of a Bad Credit Score on Future Installment Loans

So, why are we discussing how repaying a loan early affects your credit in the first place? Well, this is an important topic because of how important your credit score can be to your financial profile and your life in general.

Having bad credit can have a number of negative side effects, like:

  • It can make it more difficult to secure a loan or to qualify for different forms of credit.
  • If you do manage to be approved for a loan with bad credit, the interest rates will often be higher than if you had good credit.
  • You may end up paying more for certain types of insurance, like renter’s or homeowner’s insurance.
  • It could affect your ability to secure certain jobs, as some employers may check your credit before offering you the role.

Make sure to stay on top of your payment schedules, monitor how much of your available credit you’re using, and keep in mind any of the other factors we mentioned that affect your credit score. If you can manage these things well, you may be able to have a positive effect on your score.

Learn More About Your Loans

It’s not always easy to make the right financial decisions for your situation, but it’s important you do your best to educate yourself as much as possible. If you’re looking for guidance, look to the experts at MoneyKey to learn more about installment and payday loans online, credit scores, and other financial topics. The more you know, the better chance you’ll give yourself to make the best financial decisions possible!

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