Paying off a loan early could help you save money on interest, but it could cost you a few points off your credit score. Closing loan accounts can affect things like credit utilization, payment history, and credit mix, all of which factor into your score.
Does that mean you shouldn’t pay off a loan early if you have the opportunity to do so? Not at all. But it’s important to consider how your score may be affected if you decide to pay a loan in full ahead of its scheduled payoff date.
What Is a Personal Loan?
A personal loan is a loan that’s designed for personal use. When you get a personal loan, your lender agrees to give you a lump sum of money that you can use for just about anything. Some common uses for a personal loan include:
• Debt consolidation
• Credit card refinancing
• Medical bills
• Large expenses, such as a wedding or vacation
Personal loans are repaid in installments, according to the schedule set by your lender. For example, you might pay $350 a month for 36 months to pay off a personal loan. Each loan payment includes principal and interest, and your lender may also charge fees, such as origination fees.
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Can You Pay Off a Personal Loan Early?
Unless your loan agreement specifically states that you must agree to pay every installment as scheduled, then you should be able to pay off the balance early.
Keep in mind that paying off a personal loan before the loan maturity date may trigger a prepayment penalty. This is a premium you pay to your lender for ending the loan agreement ahead of schedule. Lenders charge these penalties to recoup any interest they might miss out on if you pay off your loan sooner rather than later.
If your lender charges a prepayment penalty, they should tell you that up front. At a minimum, any prepayment penalties or other requirements for paying off a loan early should be disclosed in your loan paperwork.
Does Paying Off a Personal Loan Early Hurt Your Credit Score?
Paying off a personal loan early can hurt your credit score, at least temporarily. To understand why, it helps to know a little more about how credit scores are calculated.
As an example, let’s use FICO® Credit Scores, which are the most widely used among major lenders. Here’s how these scores break down:
• Payment history. Payment history accounts for 35% of your FICO score. Paying on time builds your score, while late payments can hurt it.
• Credit utilization. Credit utilization refers to how much of your available credit you’re using at any given time. This factor represents 30% of your FICO score.
• Credit age. Your credit age is the overall average length of your credit history. This factor accounts for 15% of your credit score.
• Credit mix. Credit mix is simply the different types of credit you’re using. It makes up 10% of your FICO score.
• Credit inquiries. Inquiries show up on your credit report when you apply for new credit. They make up the last 10% of your FICO score.
Why does paying off a loan hurt credit? It has to do with some of the factors listed above.
When an account moves from open status to closed, that means you’re no longer racking up points for on-time payments. You’re also affecting your overall credit utilization and credit mix. That combination can mean a dip in your score, though it’s less drastic than what you might see if you were to suddenly stop paying your debts or max out your credit cards.
When does paying off a debt help your credit score? When you have high credit limits but low balances, that’s good for your credit utilization — assuming that you’re not closing credit card accounts after paying them off.
Your score is less likely to suffer a drop after paying off a loan if you have other debts that you’re making on-time payments to and a healthy credit mix. Signing up for free credit score monitoring can help you keep track of score changes over time and the factors that might cause your score to go up or down.
Does It Make Sense to Pay Off a Loan Early?
Paying off a loan early can make sense if you would like to clear the debt and have the cash to do so. Here’s what paying off a loan early might do for you:
• Eliminate a monthly payment in your budget so you have more cash to direct toward other financial goals.
• Potentially save money on interest, since you’re not making any additional payments to the lender.
Whether you should pay off a loan early depends on your personal debt repayment plan and strategy. Keep in mind that it’s not always the right solution. For example, say that you plan to take $10,000 out of savings to pay off a personal loan early. If doing so leaves you with nothing for emergencies, then you can find yourself back in debt pretty quickly if you have to charge an unexpected expense to a credit card.
If you’re interested in the fastest ways to pay off debt, there are some options. For example, you can:
• Use your tax refund or other windfalls to pay off what you owe.
• Double up on your monthly payments.
• Make biweekly payments, which adds up to one extra full payment per year.
• Refinance the debt into a new loan with a lower interest rate.
What matters most when paying off debt is finding a method that works for your budget and situation.
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Credit Cards vs Installment Loans
Credit cards and installment loans are very different. A credit card is a revolving credit line. As you pay down your balance, you free up available credit. Installment loans, on the other hand, let you borrow a lump sum. As you pay it off, the balance goes down until it reaches zero.
In terms of how they’re treated for credit scoring purposes, credit cards tend to carry more weight. That’s because credit scores lean heavily on your credit utilization. Does carrying a credit card balance affect credit? Yes, and it can also cost you money if you’re paying a high interest rate.
Installment loans can help you build a positive payment history. They can also enhance your credit mix. Examples of installment loans include personal loans, car loans, federal student loans, private student loans, and mortgage loans.
How much does paying off a car loan help credit? What about student loans? The biggest boost you’ll get from paying off installment loans is with your payment history. As long as you’re making your payments on time each month, your score can benefit. That can show lenders that you’re responsible about meeting your debt obligations.
Additional Considerations About Paying Off a Personal Loan Early
If you’re thinking of paying off a personal loan early, it helps to weigh the pros and cons. Credit score aside, here are a few other questions to consider:
• Do I have enough money to pay the balance in full without draining my cash reserves?
• Am I planning to apply for new credit after paying the loan off?
• Will the lender charge a prepayment penalty? And if so, how much will it be?
You can ask these same questions if you’re paying off a different type of installment loan, such as a car loan or a student loan.
It’s also helpful to think about what you’ll do with the money that you’ll be freeing up in your budget. For example, you might decide to park it in a high-yield savings account or invest it to start growing wealth for retirement.
Keep an Eye on Your Credit When Paying Off a Personal Loan Early?
If you’re planning to pay off a personal loan early, it’s a good idea to check your credit scores regularly. While you’re making payments, you can monitor your scores to see what kind of positive impact they’re having. Once you make the last payment, you can go back and see if doing so helped or hurt your score.
You should make sure that the account has been properly marked as closed on your credit reports. Keeping records of all your payments is a good idea as well, in case the lender tries to come back later and say that you still owe.
Should your credit score go down after paying off a loan, the best way to bring it back up again is to make on-time payments to other debts. Paying down credit card balances and limiting how often you apply for new credit can also work in your favor.
Paying off a personal loan early can save you some money on interest charges and free up cash for other goals. Before paying off a personal loan before maturity, it’s helpful to consider how it might affect your credit score.
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Is there a downside to paying off a loan early?
Paying a loan off early can impact your credit score negatively if it affects your credit mix or payment history. Your lender may also charge you a prepayment penalty to recoup lost interest.
Why does credit score go down after paying off loan?
Credit scores can go down after paying off a loan because you’re no longer benefiting from making on-time payments. You may also see a score loss if you no longer have an installment loan showing in your credit mix.
Does it hurt your credit score if you pay early?
Paying early on a loan can hurt your credit score if you’re no longer seeing on-time payments reported to the credit bureau. However, you can recover your score by continuing to pay other bills on time, maintaining a low credit utilization, and limiting how often you apply for new credit.
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