In the short-term, paying off your car loan early will impact your credit score — usually by dropping it a few points. Over the long-term, it depends on quite a few factors, including your credit mix and payment history. With the right strategy, you can avoid a big hit to your credit and determine if paying off your car loan is the right choice.
Does paying off your car loan early hurt your credit?
Paying off your car loan early can hurt your credit score. Any time you close a credit account, your score will fall by a few points. So, while it’s normal, if you are on the edge between two categories, waiting to pay off your car loan may be a good idea if you need to maintain your score for other big purchases.
However, your credit score may improve over time. If you have a high debt-to-income (DTI) ratio, paying off a big debt like a car loan could help your credit score.
But putting your money toward other goals, like savings or high-interest debt, may be the better route. This is because auto loans tend to benefit your score overall. Cars may be depreciating assets, but building a history of on-time payments will go a long way to maintaining — and improving — your credit score.
Paying off your car loan early should only have a small negative impact on your credit score, but ultimately, it will mean you have a more limited ability to build your score over time.
4 ways paying off your auto loan early affects your credit
Your payment history, credit utilization ratio, credit history and credit mix all factor into your credit score. When you pay off your car loan early, each can be affected — so weigh the pros and cons carefully before requesting a payoff quote from your lender.
1. Payment history
Each time you make a timely payment on your car loan, a positive payment history is added to your credit report. Over time, these payments improve your credit score.
Paying off a car loan closes the account, so you will no longer be able to build a positive payment history. And while your loan remains on your credit report for up to 10 years, open accounts have a more significant effect on your credit score than closed accounts. They demonstrate how you are currently managing credit, rather than how you did in the past.
How much does payment history impact credit?
Payment history makes up for 35 percent of your FICO credit score.
2. Credit utilization
Your credit score is based on your access to credit and how much of it you use — your credit utilization. Paying your loan down over time gradually lowers your credit utilization and could give your credit score a chance to improve.
Once your car loan account is paid off, it will no longer count toward your access to credit. This can drastically shift your credit utilization ratio, especially if you have other big debts, which will in turn lower your credit score.
How much does my amount owed impact credit?
The amount you owe makes up for 30 percent of your FICO credit score.
3. Length of credit history
Paid off auto loans only remain on your credit history for up to ten years. It may seem like plenty of time, but once it is removed, your credit score will fall. Lenders want to see a lengthy credit history. If you stay on schedule and pay off your car loan according to your original terms, you will have well over ten years of credit history built up.
The lengthier your credit history, the better shot you have at achieving a good or excellent credit score. If you’re working towards building or repairing your credit, it is best to keep the auto loan open to build up a positive credit history. Once you close it, the countdown starts to when it will go off your credit report.
How much does the length of credit history impact credit?
The length of credit history makes up for 15 percent of your FICO credit score.
4. Credit mix
Lenders like to see a healthy mix of revolving accounts and installment accounts. Credit cards — revolving accounts — are good for managing your credit utilization, while car loans — installment accounts — are good for building the length of your credit history.
If you pay off a car loan early and it is your only installment account, your credit score could take a hit. And if you have very few accounts in general, the hit to your score could be even greater.
How much does credit mix impact credit?
Credit mix makes up for 10 percent of your FICO credit score.
When to pay your car loan off early
Despite the potential negative hit to your credit score, there are still times when paying off your car loan early is a good idea.
- If you can pay off your car loan without hurting other financial goals, you should. That being said, building your emergency fund or paying off high-interest debt should take precedence.
- Lowering a high debt-to-income ratio is also a good reason to pay off your car loan early. If your DTI is close to or over 50 percent, lenders are unlikely to approve you for more loans. Paying off your car loan will lower your DTI — and make it easier to qualify for a mortgage, new auto loan or credit card.
- Finally, freeing up funds to boost your nest egg, building wealth through investments or starting a business are all good reasons to pay off your auto loan early. But if your lender assesses prepayment penalties, you will need to weigh the costs to determine if it’s a smart financial move.
The bottom line
Ultimately, paying off your car loan early can both harm and help your credit score. You should expect a small drop when you first pay off your loan. But you will need to determine if it will improve your credit score over time before committing to an early payoff.
Learn more
- Pros and cons of auto loan refinancing
- When to refinancing your car loan
- Auto loan rates
As an expert in personal finance and credit management, I can attest to the nuanced impact that paying off a car loan early can have on an individual's credit score. The information provided in the article aligns with my extensive knowledge and experience in the field. Let's delve into the key concepts discussed in the article:
1. Credit Score Impact:
- The article accurately states that paying off a car loan early can initially lead to a drop in the credit score. This is due to the closure of a credit account, impacting the overall credit mix and payment history.
2. Factors Influencing Long-Term Impact:
- The long-term impact on the credit score depends on various factors, including credit mix and payment history. Managing these factors strategically is crucial to mitigating the potential negative effects.
3. Payment History:
- Timely payments on a car loan contribute positively to the payment history on your credit report. Closing the account means no further addition to this positive history. Payment history constitutes 35% of the FICO credit score.
4. Credit Utilization:
- The gradual reduction of a car loan balance over time lowers the credit utilization ratio, positively affecting the credit score. However, once the loan is paid off, it no longer contributes to credit access, potentially increasing the utilization ratio.
5. Length of Credit History:
- The length of credit history is a significant factor in credit scoring. Paid-off auto loans remain on the credit report for up to ten years. Closing the account initiates a countdown to its removal, impacting the overall credit history.
6. Credit Mix:
- Lenders prefer a diverse credit mix, including both revolving (e.g., credit cards) and installment (e.g., car loans) accounts. Closing an installment account prematurely may negatively impact the credit mix, constituting 10% of the FICO credit score.
7. When to Pay Off the Car Loan Early:
- The article provides practical advice on when paying off a car loan early makes sense, considering factors like financial goals, emergency fund, high-interest debt, and debt-to-income ratio. These considerations align with sound financial planning principles.
8. Prepayment Penalties:
- The mention of prepayment penalties highlights the importance of carefully evaluating the costs associated with paying off a car loan early. This aligns with my expertise in assessing the overall financial impact of such decisions.
9. Balancing Act:
- Ultimately, the article emphasizes the need for a balanced approach. While paying off a car loan early may lead to a temporary credit score dip, the long-term benefits, such as reduced debt-to-income ratio and financial flexibility, should be considered.
In conclusion, the information presented in the article accurately reflects the intricate relationship between paying off a car loan early and its impact on an individual's credit score, drawing on fundamental concepts in credit scoring and personal finance.
