The answer is more complex than you might think. Paying off a car loan can help your credit profile by reducing your debt-to-income ratio. But closing out a loan can also have several negative effects on your credit history. And paying off a loan early isn’t the best decision when there are better ways you can use that money — or save it for an emergency.
We’ll discuss how much paying off a car loan helps your credit, and when paying it off early really does pay off.
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How Credit Scores Are Calculated
The fact that you got a car loan means you know a little something about your credit score. But it’s always helpful to learn more about how those scores are calculated. According to FICO® Score, your credit rating is made up of five parts:
• Payment history (timely payments): 35%
• Amounts owed (credit utilization): 30%
• Length of credit history: 15%
• New credit requests: 10%
• Credit mix (installment versus revolving): 10%
Whether you’re applying for a personal loan or a car loan, the same factors are used to determine your creditworthiness.
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Does Paying Off a Credit Card Help Your Credit?
For the sake of comparison, let’s say you buy a car with a credit card. (In real life, this is usually a bad idea because credit card interest rates are considerably higher than for auto loans.) How would paying off the credit card balance affect your credit score?
No matter what you’ve heard, maintaining a credit card balance doesn’t help your score. That’s because the amount you owe, also called credit utilization, accounts for 30% of your score. To calculate your credit utilization, add up the credit limits on your cards. Then divide that figure by your outstanding balance(s).
Let’s say your credit limit is $20,000. If you buy a used car for $10,000, you’re utilizing 50% of your available credit. So paying down your balance — or paying off the whole $20K — will boost your credit utilization factor.
But there’s a key difference between paying off a credit card and paying off a car loan. After you pay off the credit card balance, the account remains open (unless you take action to close it). This is called revolving credit: You can repeatedly use the funds up to your credit limit, as long as you continue to make payments.
How Paying Off Your Car Loan Early May Affect Your Credit Score
A car loan is considered an installment loan, one with a starting balance that’s paid down each time you make a monthly payment. According to credit reporting agency Experian, paying off an installment loan can briefly cause your score to dip.
That’s because the loan is no longer “active,” so your timely payment history is no longer contributing to your overall credit score. Paying off an installment loan can also affect a person’s credit mix and the average age of their open accounts.
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How To Decide Whether To Pay Off Your Car Loan Early
There’s no one answer that fits every borrower. See which pros and cons below apply to your situation.
When It’s a Good Idea To Pay Off Your Car Loan Early
If any of these statements resonate with you, paying off your car loan early is likely the right decision.
• You have trouble juggling your monthly bills and would be glad to have one fewer to deal with.
• You hate the idea of continuing to pay interest on the loan.
• The money you free up can be used to pay down another debt, add to your savings, or spend on pursuits you’re passionate about.
• You’re considering taking out another loan, and paying off this one could help you qualify.
But wait! Check out the drawbacks to paying off a loan below before you decide.
When It’s Better To Keep the Loan
Even if you’re eager to pay down some debt, sometimes you’re better off financially keeping a loan. See if any of these disadvantages affects your cost-benefit analysis.
• Instead of paying off the loan, investing the lump sum might net you more profits than you’ll save in loan interest.
• If you’re using savings to pay off the loan, you may find yourself short in an emergency.
• Some loans come with prepayment penalties. Make sure you won’t be charged for paying off your loan ahead of schedule.
• As noted above, paying off an installment loan can have a negative impact on your credit mix, payment history, and length of credit history.
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About To Make Your Last Scheduled Loan Payment?
Now is the perfect time to test how much paying off the loan will impact your credit score. You can find your credit score for free at AnnualCreditReport.com. Check your score before you make your final payment, and again a month or so later.
Or you can sign up for a service that monitors your credit score for you. What qualifies as credit score monitoring varies from service to service. Look for one that will alert you whenever your score changes.
You’ll also want to decide how you’re going to use those funds going forward. You may decide to pay off other debts (especially credit cards), build your savings, or invest the funds. A money tracker app can give you a helpful overview of your finances.
Paying off a car loan can sometimes lower your auto insurance premium. Check with your insurance carrier, and shop around to make sure you’re getting the best deal.
The reality is that paying off a car loan may cause your credit score to dip. But it can still be the right decision if you have plenty of savings to cover the balance due. After all, you’ll save money on interest, lower your debt-to-income ratio, and have one fewer monthly bill to juggle. It depends on your financial circumstances, and if you have other, higher-interest debt that should be paid off first.
With SoFi, you can manage your money while also benefiting from free credit monitoring. Connect all of your accounts on one mobile dashboard to see the big picture and receive financial insights based on your profile.
How much will my credit score go up if I pay off my car?
Your credit score may actually dip, but it depends on your specific financial situation. That’s because paying off an installment loan can have a negative impact on your credit mix, payment history, and length of credit history.
Will paying off a car loan early improve credit?
Each situation is unique. Paying off a loan will improve your debt-to-income ratio, which lenders look at to determine your creditworthiness. However, it can also have a negative impact on your credit mix, payment history, and length of credit history.
Why did my credit score drop when I paid off my car early?
Credit score algorithms are complex, and every borrower’s situation is different. If your car loan was your only installment loan, closing it reduced your credit mix, which accounts for 10% of your score. Paying off a loan can also reduce the overall length of your open credit accounts, another factor used to calculate your score.
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