Does Paying Off Loans Early Affect Your Credit Rating?
Paying off your loan early can save you money and free up some of your monthly cash flow. However, if you are rushing to get rid of the loan in hopes of improving your credit, you might want to slow down. Simply paying loans off early, regardless of the type, will not raise your credit score. Depending on your credit history and goals, however, closing the account may help you in other ways.
You do not receive additional points on your credit score for satisfying your loan agreement ahead of schedule. If you have limited credit history, it is best to leave the account open until you are approved for other accounts. According to Experian, a major credit reporting bureau, open and active accounts are scored higher than closed accounts. Paying off the loan early can save you some money in interest, but it does not help your credit. The type of credit you have also affects your score. A mixture of credit, including both installment and revolving accounts, tends to score higher than having only one type of credit.
If you already have an established credit history, paying off your loan early may help you in other ways. When you pay off your loan, you have one less bill to pay each month. Your debt-to-income ratio is the percentage of your gross monthly income applied towards debt. Although your debt-to-income ratio is not a credit score factor, lenders typically assess the amount of debt you have to ensure you are able to afford taking on a new account. If you have too much debt, the lender may see you as a risk.
Instead of paying off your loan and closing the account, consider paying down the balance. Credit utilization, sometimes called debt utilization, is a factor in 30 percent of your FICO score. Each individual account is scored based on the percentage of available credit compared to the limit. The accounts are scored separately and together to determine the total amount of credit you are utilizing. FICO does not reveal an exact ideal number, but it is best to keep it as low as possible. If you have high credit card balances or a new mortgage, paying off a large portion of your personal or auto loan can help lower the ratio.
Regardless of whether you pay off the loan early, make sure all payments are made on time. Your payment history accounts for 35 percent of your FICO credit score. If you decide to pay off your loan, it will still remain on your report for seven years as a closed account that was paid as agreed. Watch out for prepayment penalties if you decide to pay off the loan early. Some lenders charge a fee that equals a certain percentage of the interest remaining on the loan.
Jeannine Mancini, a Florida native, has been writing business and personal finance articles since 2003. Her articles have been published in the Florida Today and Orlando Sentinel. She earned a Bachelor of Science in Interdisciplinary Studies from the University of Central Florida.
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It’s not always smart to pay off your student loans early
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Q. How do I know whether it is a good deal to pay off a student loan early? More than nine years ago, I owed $10,000 in student loans to one provider who offered a $2,000 discount if I paid it off immediately. The loan from a local community organization had a zero percent interest rate at the time. Should I have taken the deal?
A. Zero percent student loans are rare. But other people might face similar questions if they have low rates on auto loans, credit cards and other debt: Is it smart to pay the loan off early, even though it isn’t accruing much interest — or any interest at all? Should the cash be used for something else?
The answer depends on a number of factors, including how much a person has in savings, if he or she has any other debt and if the money can help them meet some of their other goals, financial advisers say.
Generally speaking, there are few benefits to paying off a zero-percent loan early, says Beth V. Walker, a financial planner who specializes in helping families figure out how to pay for college. Instead, it may be smarter to use the money to pay off more expensive debt, pad savings or invest in other goals, she says.
For instance, think of someone who also has credit card debt, which can often grow at an annual percentage rate of 20 percent or more. Instead of putting any extra cash toward the zero-interest-rate student loan that isn’t growing, it may make more sense to put those extra payments toward the credit card debt as a way to reduce interest charges, says Betsy Mayotte, director of consumer outreach and compliance for American Student Assistance, a nonprofit organization that offers guidance to families paying for college.
Most student loan borrowers won’t see this kind of offer to reduce what they owe unless they are struggling to keep up with their payments, Mayotte says.
On a purely financial basis, it could be more cost-efficient to pay off the loan early in exchange for the smaller debt load, Mayotte says. The discount could be viewed as a return of 20 percent or a windfall of $2,000. Consumers may struggle to find that kind of return anywhere else at a time when savings accounts aren’t paying much and stocks are looking expensive.
But even with that discount in mind, consumers should ask themselves how much money they would have left in the bank after the student loan is paid off, Mayotte says. If paying off the loan is going to wipe out a person’s savings, then maybe it is best for him to hold off, she says. Otherwise, he might have to turn to credit cards when emergencies happen, which could lead to interest charges that would eat into any savings earned by paying off the loan early.
Consumers also need to think about whether the money could help them meet some other long-term goals, Walker says. For example, if the cash could be used to pay for a higher education course that could help a person land a higher-paying job, the payoff could be much larger than the $2,000 that would be saved by paying the loan off immediately, she says.
Some people might want to use the cash to help them afford the equipment or classes they need for a career change. Other people may consider using the cash to go toward a down payment for a house or to pay for a home improvement that could improve their quality of life, Walker says. “Sometimes you invest in things that don’t show up on a financial balance sheet, but they show up on a personal balance sheet,” she says.
This is a feature in which we talk to experts about the personal finance questions that stump readers.