It could appear that repaying a vehicle loan would be beneficial for your credit rating. However, the truth is more complicated, and although eliminating a monthly car payment might clearly be beneficial for your budget, paying off a car loan in some circumstances can actually lower your credit score.
How Credit Score is Determined
In order to assess the effects of paying off an auto loan, you must first understand how your credit score is calculated. Paying off a vehicle loan will have an effect on at least four of the six key elements; we will discuss the three most significant below.
Your payment history, which accounts for around 35% of your credit score, is the most important aspect. Your credit score will rise if you pay off a vehicle loan since it demonstrates you will have a history of making your payments on time. On the other hand, making late payments will lower your credit rating. To keep your credit score high, it is essential to make all of your payments on schedule.
Credit Utilization Ratio
The credit utilization ratio measures how much of your available credit you are utilizing. This ratio accounts for about 30% of your credit score. To maintain a decent credit score, keep your credit use percentage around 30%. Having extra credit available after paying off a vehicle loan might reduce your credit usage ratio and raise your credit score.
Length of credit history
Your credit score also takes into account the length of your credit history, which accounts for 15% of your overall score. Your average credit history length may be shortened after you pay off a vehicle loan since the loan will be removed from your credit report. The effect of losing one credit line will be lessened, though, if you have several credit accounts with a lengthy history of on-time payments. Longer credit histories are often seen more favorably by lenders since they demonstrate a history of careful credit usage.
In addition to payment history, credit utilization ratio, and length of credit history, other factors can also affect your credit score, such as the types of credit you have, new credit inquiries, and any negative information on your credit report.
Impacts of Paying Off an Auto Loan
While it might make sense that credit scores would go up when you pay off a debt, lenders want to see if you can manage borrowed money. In the case of auto loans, paying them off can hurt your credit score because the number of open lines of credit dramatically impacts your overall credit score. The types of credit you have can affect your credit score because it shows lenders you can manage different types of credit responsibly. For example, having a mix of credit cards, car loans, and a mortgage can be seen as more favorable than having only one type of credit, such as multiple credit cards. Paying off an auto loan can reduce this mix.
New credit inquiries can also affect your credit score, as they show you are applying for new credit. Too many inquiries in a short period of time can be seen as a red flag by lenders, as it may indicate that you are in financial distress or are taking on too much debt.
Finally, any unfavorable information on your credit report, such as a bankruptcy or collections account, can harm your credit score. It is essential to address any negative information on your credit report and work to improve your credit score over time.
Should I Keep the Loan or Pay It Off Early?
There are a few scenarios where paying off your loan could be helpful. If you are paying a high-interest rate, consider paying the car loan early to reduce the total amount you pay. Some lenders charge you for paying off the loan early with a prepayment penalty. If you do find you will get hit with a charge, looking into refinancing may be a good idea. TDECU offers a wide range of services to assist borrowers, including auto loan refinancing. You may also want to repay an auto loan to purchase a home. Lenders look at your debt-to-income (DTI) ratio when approving a new loan, so paying off your auto loan balance can improve your chances of qualifying for a mortgage.
There are also a handful of scenarios where keeping your auto loan is a good idea, even if you can pay it off. For one, if you are close to paying off your auto loan, it is better to keep it and make those final loan payments on time. Avoiding late payments positively impacts your credit score, so why not just see the loan out? Also, saving your extra cash is a good idea if you do not have an emergency fund. Experian recommends you have three to six months of expenses saved, so if you do not have that lump sum in your savings, you might want to keep the loan and put that money in an emergency fund.
Considering the various factors that go into calculating your credit score, it becomes clear how paying off debt can hurt your credit score. Since credit scores indicate how you manage borrowed money when you close a line of credit, the “amounts you owe” category immediately goes down, which means there is less borrowed money for you to manage well. It is better for your score to continue to make on-time payments than to close a line of credit. Your auto loan may be one of your oldest lines of credit, and paying it off means you do not have that length of time on your side. Your score may also be hurt because not having an auto loan means your credit mix changes, and lenders like to know you can properly manage all different types of credit.
Like many things in personal finance, figuring out which loans to keep and which ones to possibly pay off can feel overwhelming. To make the right financial decision, consider your goals, credit score, and interest rates. You can also contact one of our experienced advisors, who can help you every step of the way.