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By Lois Sullivan
People often suggest you pay down your credit card accounts as it can help your credit score. But does that work for other credit accounts, such as an auto loan? Does paying off a car loan help a credit score? You might assume that paying off an auto loan will immediately help your credit. However, that often isn't the case. Your credit score may take a temporary dip after paying off the loan. The reason is you are closing an active account.
To understand how paying off a car loan can impact your credit score, you first need to know how credit scores work. In general, your score goes up and down based on how well you have been managing the borrowed funds. How exactly credit scores are calculated is a well-kept secret, but several categories impact your ultimate score:
To help maximize your credit score, it's essential to pay your accounts on time, not keep your balances at the top of your credit limits, and have different types of accounts.
When you pay off an account, it will no longer help establish a payment history. That is one reason why your credit score may initially dip. Your credit score might not decrease as much if you have other accounts you pay in installments. Installment accounts, especially those that have been open for a considerable amount of time, can help.
Auto loans that are several years old could cause your length of credit history category to decrease if there is nothing to offset the account. That is because you're eliminating a long-established account on your credit report. Your average age on all accounts will decrease.
The amounts you owe will also potentially take a hit. As you pay down the car loan, your score should increase because you've almost paid off the auto loan. This arrangement may sound confusing, but credit score calculators love open accounts with low balances. Owing 5% or less of your original loan balance is better than a closed account. Once you pay off the loan, your account will move to closed and paid.
Your credit mix section could also suffer if you don't have other auto loans or installment accounts. This section is a minor component in your overall rating percentages. Don't worry about the credit mix if the other ones are fine.
If you choose to pay off your auto loan earlier than the schedule shows, it could impact your score because you have less payment history data.
Unfortunately, there's no specific total number of points your score will decrease. Your overall financial situation will impact you differently than another person. One individual might see a drop of four points while another person sees a decrease of eight points. If you consider paying off your loan early, make sure the rest of your accounts are in good standing and your balances aren't too high.
Paying off your auto loan ahead of schedule may not necessarily help your credit score, but you can derive some benefits if you choose to pay it off. However, you must check to verify whether your loan contains any clause about prepayment penalties. This penalty occurs if you pay off your loan ahead of schedule. Be sure to read your documents carefully before deciding whether paying off the loan early is worth it.
Also, consider your other debts. Can you afford to pay off your loan without jeopardizing your other accounts? Other debts with a higher percentage rate could be better to pay off first, especially if you have a low-interest auto loan.
You will also want to check the type of auto loan you have. A car loan with simple interest means you will be paying principal and interest on what you owe at that time. Precomputed interest loans mean your interest is fixed and calculated at the start of the loan. Even if you pay off the loan early, you won't be saving any interest.
Some of the benefits of paying off your auto loan could include:
Be sure to thoroughly review your finances and loan documents before deciding whether to pay off your auto loan ahead of schedule.
Some people might be better off paying their auto loan as scheduled. Aside from the issues mentioned earlier about precomputed interest or prepayment penalties, you should consider other factors. If you are close to the end of your loan, you won't be saving a significant amount of interest. It may be better for your credit to continue making on-time payments each month.
Do you have an emergency fund? If not, you should allocate any extra money to establish some savings.
You might be worried about your score decreasing, even by a few points. You are still telling future lenders that you can successfully fulfill your financial obligations by paying off the loan. This activity could help you qualify for a future auto loan or other types of credit. Many lenders don't look solely at your credit score. Instead, they look at your credit report as a whole. A prior car loan could be more important than your credit score, depending on the lender.
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