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Although paying off your car loan is satisfying, it will not increase your credit score. Often, paying off your car loan will actually hurt your credit score.
Closing an active account may negatively affect some factors that influence your score. These factors may include your credit mix and the average age of the accounts in your credit history.
What Happens After You Pay Off Your Car Loan?
Paying off your car loan will mean that you should have more monthly cash flow. You can reallocate this money towards savings, pay off some other debts, and other options.
The information in your credit history is the basis for your three-digit credit score. Experian, Equifax, and TransUnion, the three main credit bureaus, compile your credit history.
The majority of lenders today use the FICO credit scoring model. FICO develops models that use formulas to calculate credit scores.
A car loan is an example of an installment loan, along with student loans, personal loans, and others. Another category is revolving credit accounts, most notably, credit cards.
Your credit mix is one of the factors used in FICO calculations. Having a mix of both installment and revolving accounts helps your FICO Score.
When you pay off a car loan, the account is no longer active. If the car loan was your only installment account, this will negatively impact your credit mix.
In the meanwhile, closing the car loan also might impact your average age of active (open) accounts. The negative effect is likely most dramatic if the car loan was your oldest active account.
Per FICO, many consumers without active installment loans maintain credit scores well above 700. Also check out our article, “Can I Get a Car Loan With a Credit Score of 600?” to see if it’s possible.
How Your Credit Score is Calculated
Did you know that you can have more than one credit score? First, variations exist when the data received by the three credit bureaus differs.
This occurs because not all lenders report to all three bureaus. Some lenders use a combined score based on the reports from all three credit bureaus.
As stated earlier, FICO is the largest and most widely used scoring model. Yet, a competing model known as VantageScore also exists.
The FICO and VantageScore models calculate scores using a similar set of criteria. Both models maintain compliance with the guidelines of the Equal Credit Opportunity Act (ECOA). The models differ slightly in the value or degree of influence applied to each set of criteria.
Both FICO and VantageScore also generate industry-specific scoring models. For example, models using formulas geared for auto lenders or credit card issuers.
The following five factors or categories are the basis for the FICO scoring model. Each has a percentage indicating its degree of influence or weight.
Payment History – 35%
Payment history is the largest individual factor influencing your score (35%). Your payment history reflects how you have managed your credit accounts over time.
Lenders make decisions based on a consumer’s likelihood of repaying their debts. They recognize the importance of gauging the level of risk you represent.
Data suggests that your past payment history often indicates your future behavior. Establishing a good history of making timely payments on credit accounts is critical.
Those without a credit history often have no FICO credit score. You can’t create and increase credit score overnight. Your FICO Score will appear after having a reported credit account for six months.
Amounts Owed – 30%
This factor assesses how much total debt you currently have. Your current amount of debt is usually of secondary importance in this category.
For example, $2,000 in monthly debt obligations is excessive if your monthly income is $3,000. The same $2,000 monthly obligation is much less of a concern if your monthly income is $9,000.
Credit utilization rates (CUR) are generally a more influential factor in credit scoring. This is a ratio based on your revolving accounts, which are primarily credit cards. The CUR calculation is as follows:
CUR (%) = Total of current credit card balances / Total of all card account limits
For example, assume you have one credit card with a $1,000 balance and a $5,000 limit. Here, your CUR is 20%.
Having a credit card balance near your maximum account limit suggests you are “overextended.” Generally, strive for a CUR below 10%.
Length of Credit History – 15%
FICO primarily considers your length of credit history in three ways.
- The ages of your oldest and newest credit accounts and the average age across all accounts.
- How long have certain accounts been open?
- When was the last time there was activity on your accounts?
Experts often discourage consumers from closing (canceling) old, unused credit card accounts because of these factors.
Credit Mix – 10%
Credit profiles containing both installment and revolving accounts have a good credit mix.
Installment account examples include auto loans and student loans. Revolving account examples are credit cards and home equity lines of credit (HELOC).
A good credit mix shows an ability to responsibly manage different types of accounts.
New Credit – 10%
Each time you apply for a new credit account, lenders check credit scores. This process of assessing your creditworthiness is a hard credit inquiry or “hard pull.”
Lenders view the presence of many recent hard credit inquiries as a red flag. Here, the perception is that some unexpected financial setback occurred.
Hard credit inquiries have a minor, negative effect on credit scores that will dissipate. Hard credit inquiries remain on your credit report for two years. Today, FICO only factors hard inquiries into their scoring calculations for 12 months.
When you check your credit report, a “soft inquiry” occurs. A soft inquiry will not influence your score.
Should You Pay Your Car Loan Off Early?
There are several key considerations when looking to pay off your car loan early. An early payoff might make sense if you have no other worrisome expenses. This might also apply if you already have an ample emergency fund in place.
Paying off your loan early is a good idea if you are preparing to buy a home and have a high debt-to-income ratio.
An early payoff might save you on interest expenses. Auto loans are usually simple interest loans. Also check out our “How Fast Will a Car Loan Raise My Credit Score?” if you want to know more.
Here, your monthly payment includes interest charges based on your remaining balance (principal). You should review the terms of your loan to ensure that prepayment penalties don’t apply.
If you have other higher-interest debt, you should probably pay those off first. You could also transfer the funds into a retirement account, especially if your retirement savings are insufficient.
Often, funding your retirement account has tax benefits or will generate matching funds from your employer.
You might also consider a hybrid approach. For example, make an extra payment each month that applies to the principal balance. Keep in mind that paying off your car loan early is unlikely to improve your credit score.
How Long After Paying Off a Car Loan Does Credit Improve?
Car loans are installment loans with a predefined term and recurring monthly payments. Unlike a credit card account, the account closes after you pay off a car loan.
After paying off a car loan, most consumers notice a small decline in their credit score. The drop in your credit score is usually temporary. You should expect your credit score to bounce back in a few months.
Closed accounts usually have a designation such as “closed in good standing” or “paid as agreed.” These positive entries remain on your credit report for 10 years and benefit your score.
Is It Worth Paying Off a Car Loan Early?
Borrowers with funds on hand may consider paying off their car loan early in a lump sum. Before doing so, consider a couple of other factors.
Paying off the car early boosts your debt-to-income (DTI) ratio. Mortgage lenders often have DTI limits that borrowers must meet for loan approval.
For home loans, a “front-end” DTI of 28% or a “back-end” DTI of 36% is often needed. Those planning to buy a home should take this into account.
Depending on the interest rate of the car loan, you might save significant interest. Use an auto loan payoff calculator to check. Remember to check your loan agreement to ensure that no prepayment penalties will apply.
You might consider using the extra funds elsewhere in some cases. For example, if you have higher-interest credit card debt or inadequate savings for retirement.
Does Paying Off Your Car Loan Early Hurt Your Credit?
Paying off car loans or other types of installment loans usually causes a small drop in your credit score. This results because installment loans go inactive (close) after being repaid.
One reason this occurs is that it is hindering your “credit mix.” Having both revolving (credit card) accounts and installment accounts help your credit. Particularly, this applies if you lack any other installment loan on your credit report.
Before paying off a car loan early, be sure that no prepayment penalties will apply.
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Anthony Amodeo is a regular finance writer in both business-to-business and business-to-consumer industries. Particular areas of focus include personal finance, small business, real estate, and more. He is a graduate of Kent State University. His credit scores are top tier.