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Paying off your car loan can lower your credit score, but the effects are usually temporary.
Are you thinking about paying off your car loan early? Whether to free up your budget or have the satisfaction of one less monthly bill, many consumers expect doing so will boost their credit score. Surprisingly, the opposite can occur—paying off a car loan early can cause a dip in your credit score.
Fortunately, the impact is usually short-term and may not happen to every consumer. This is because other factors and variables can affect your overall credit score. While paying off debt is a good strategy for improving your credit, doing so for a car loan doesn’t necessarily work the same way.
Keep reading to learn more about a car loan’s correlation to your credit score and everything you should know before deciding to pay it off.
In This Piece:
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- Why Credit Scores Drop
- How Car Loans Impact Your Credit Score
- Reasons to Keep a Car Loan Open
- When It Makes Sense to Pay Off
- How to Decide
Why Do Credit Scores Drop After Paying Off Car Loans?
Paying off debt is indeed a strategy to build credit, so it makes sense that some people would think it’s the right move for car loans. Anytime your credit history changes, such as information updates or a newly opened/closed account, your credit score can change.
In the case of paying off your car loan early, it will equate to closing an account. One less account shifts your credit utilization and your credit history age. These changes may lower your credit score, depending on a range of factors.
It can be disappointing to see your score drop if you’ve worked hard to establish good credit, especially if you’re balancing between the poor and fair credit threshold.
In the next section, we’ll explain how car loans affect credit utilization and other variables that affect your overall score.
How Car Loans Impact Your Credit Score
Before choosing any type of loan, it’s important to know how credit scoring works. Your credit score takes several factors into consideration, such as making the payments on time and how long you’ve been doing so. Credit bureaus monitor and compute this data using the following weighted system for each variable:
- History of payments: Making consecutive, on-time payments on loans and credit cards makes up 35% of your credit score. Timely payments are good for building credit; late or missed payments will hurt it. Paying off a car loan early closes the account completely, which may work against your positive payment history.
- Credit Utilization: The ratio of the amount you owe to the total credit limit of your accounts, factoring in how much you owe on your car loan. This ratio accounts for 30% of your credit score. Paying a loan off early changes your utilization ratio.
- Credit History: The age/length of time you’ve had open credit accounts, from your oldest reported account to the most recent, and the average age of them all. Credit age makes up 15% of your credit score. Once a car loan is paid in full, the account will “fall off” and change the average age of your overall credit—impacting your score.
- Type of Accounts: Your range of credit accounts or “credit mix” accounts for 10% of your credit score. This shows creditors you’re responsible and works in favor of your score calculation. Car loans are installment loans, which are different from credit cards (revolving credit).
- Number of Hard Inquiries: This shows the amount of times you’ve tried to apply for a new credit card/open a new line of credit, which accounts for 10% of your credit score. Creditors pay attention to this to determine your risk level.
Reasons to Keep a Car Loan Open
There are certain situations where keeping debt is beneficial. For example, having a mix of open and active accounts with a strong history of on-time payments is good for your credit score. It also shows creditors you’re responsible with loans, should you apply for another in the future.
In the following circ*mstances, paying off a car loan early can hurt your credit score:
Prepayment Penalties
Prepayment penalties are fees you’ll owe if you pay off your car loan before the term ends. Some lenders include these types of penalties in the car loan as a way to still earn interest if the client decided to pay it off early. Prepayment penalties will account for a percentage of the car loan amount, which could cost you more than you’d have paid in interest.
Make sure you check the loan agreement for any prepayment penalties beforehand. Should you decide to pay off the car loan early, you know what to expect.
Lack in Emergency Funds
Do you have enough money in emergency savings to cover car issues and unpredictable expenses that may arise? If not, you may want to delay paying off that car loan. A good rule of thumb is to save at least $100 monthly for car maintenance, repairs, and other expenses. You can leverage your car loan term by setting aside money during each payment.
Low Interest
Making timely payments on a low interest rate car loan is less expensive than those with high rates or an outstanding credit card balance. In this case, keeping the account open helps maintain a good credit mix and history, which is beneficial for your credit score.
When It Makes Sense to Pay Off a Car Loan Early
Sometimes, the trade-off of a temporary credit hit is long-term benefits. For example, if you plan on selling the car, paying off the balance to have the vehicle title beforehand can make the process easier.
Here are other scenarios when paying off your car loan early is typically a good decision:
To Save Money
Depending on your financial situation, closing an installment account means one less bill to worry about, especially when trying to save more cash each month. Paying off a car loan early makes sense if you plan to build up a rainy-day fund or to put extra money toward paying off collections and other debt.
To Lower Debt-to-Income Ratio
Since the credit utilization ratio is a high-weighting factor of your credit score, paying off debt to lower the utilization is essentially a smart move.
If your car loan accounts for a large portion of your debt, it makes sense to pay it off. Your score may drop initially when the account closes but should bump up your credit score shortly after.
To Avoid High Interest Rates
You’ll pay a lot more in interest over the course of a long-term car loan, such as in installments that are six or more years. Additionally, even average-length terms with high interest rates will do the same. If there is no prepayment penalty, paying off your car loan early is a good way to reduce the amount of interest over time.
How to Decide
When considering paying off your car loan early, think about whether or not the benefits of doing so will outweigh the score drop. Is your score fairly high and in good standing? If so, dropping a few points won’t change much. On the other hand, understand that paying off a car loan early may work against your credit score, depending on the variables above.
Instead, review your financial goals and look into other ways that will help raise your score. This consists of keeping a good mix of credit accounts, limiting new inquiries, and making all your other payments on time.
Additionally, you can use credit monitoring services like ExtraCredit® that help you track your credit scores and any changes in your credit history.
Find the tools to help you work toward your financial goals and earn rewards on select offers along the way by signing up today.
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