Credit Score

How Does Paying Off a Loan Affect Your Credit Score?

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With credit playing such a huge factor in your financial future, it’s no wonder we look for ways to maximize our credit scores. One common strategy for building your credit score is to pay off credit card debt. It can give your credit score a nice boost, especially if you’re carrying a large balance.

It may seem logical, then, to assume that the same strategy must apply to other types of accounts — like a car or home loan, for example. And if you follow this theory, paying a loan off early might sound like a great strategy for building your credit score. Unfortunately, you may be making yourself less credit-worthy, according to scoring models.

When it comes to credit scores, there’s a big difference between revolving accounts (credit cards) and installment loan accounts (i.e. a mortgage, student loan). Paying an installment loan off early won’t earn you any additional credit score points, and keeping them open for the life of the loan may actually be a better strategy for your credit score. Let’s take a look.

Credit Cards vs. Installment Loans

Credit cards are revolving accounts, which means you can revolve a balance from month to month as part of the terms of the agreement. And even if you pay off the balance, the account stays open. A credit card with a zero balance (or a very low balance) and a high credit limit is very good for your credit score. Installment loan accounts are very different.

An installment loan is a loan with a set number of scheduled payments spread over a pre-defined period of time. When you pay off an installment loan you’ve essentially fulfilled your part of the loan obligation — the balance is brought to $0 and the account is closed. This doesn’t mean that paying off an installment loan isn’t good for your credit score — it is. It just doesn’t have as large of an impact because the amount of debt on individual installment accounts isn’t as significant a factor in your credit score as credit utilization is.

Now that we’ve clarified the difference between credit cards and installment loans, let’s consider what happens to your credit score when you pay off an installment loan, and whether or not it’s a good idea to pay the loan off steadily over time or to pay it off early. Paying off an installment loan affects your credit score in a couple of ways:

Number of Accounts With Balances

The number of accounts with balances is one of many factors in your credit score. When you pay off a loan you’ll have one less account with a balance, which is good for your credit scores.

[Related Article: Can Paying a Credit Card Bill Weekly Hurt My Score?.]

Types of Credit and Length of Credit History

Credit scores love to see a number of different types of credit accounts, from auto loans and home loans, to student loans and credit cards. It shows that you’re able to manage different types of credit and it’s good for your credit score. Credit scores also like long credit histories and well-aged accounts. And when you pay off a loan, the account is closed.

So how does this affect your credit score?

A common misconception is that when you close an account, the type of account and how long it was open are no longer considered in the score calculation. This is a little misleading because credit scores — the FICO score in particular — actually factor in both open and closed accounts. The confusion exists because closed accounts will eventually fall off of your credit report, but not for quite a while. Closed accounts with late payments remain on your credit report for 7 years — and if the account was in good standing and paid as agreed, it can actually remain in your credit report for up to 10 years.

Paying Off an Installment Loan Early

If you’re thinking about paying an installment loan off early, keep in mind that credit scoring models like to see open, active accounts with a solid history of on-time payments. Paying off an installment loan early will most likely not hurt your score, but leaving it open and managing it through the term of the loan shows that you can manage and maintain the account responsibly over a period of time — which is very good for your credit score.

Bottom Line

Paying off a loan and eliminating debt, especially one that you’ve been steadily paying for an extended period of time, is good for both your financial well-being and your credit score. But if you’re thinking of paying a loan off early solely for the purpose of boosting your credit score — don’t. Pay it off instead because you’re looking to save money in interest or because it’s what’s best for your financial situation.

[Credit Cards: Research and compare credit cards at Credit.com.]

Image: Helga Weber

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  • http://www.credit.com/ Credit.com Credit Experts

    Siya –
    You are wise to be looking at your scores now, because your scores will affect the interest rate you are offered. This blog post may be useful to you in deciding how and when to pay off those loans: The Right Way to Pay Off Debt to Get a Mortgage.

  • http://www.Credit.com/ Gerri Detweiler

    Lily – It is worth a try. Why not?

  • http://www.Credit.com/ Gerri Detweiler

    It’s perfectly fine to pay off your student loans. You don’t have to carry debt to have a good score, and they don’t just disappear from your credit reports when you pay them off.

    It would be a good idea to check your credit score, You can do that using Credit.com’s free Credit Report Card which will tell you what factors are affecting your score.

  • http://www.Credit.com/ Gerri Detweiler

    Don’t worry too much lulu. That reference won’t disappear from your credit reports when it is paid off. However, it is good for you to have more than one account reporting. Do you have a credit card? If not, consider getting a secured credit card to build another credit reference.

  • http://www.credit.com/ Credit.com Credit Experts

    I’m afraid we’re uncertain about how credit scores work in the UK. As far as an appeal goes, it never hurts to ask. Credit.com had a post about overturning credit card rejections. Though the particulars in your case will be different, the general advice may be useful: The Art of Overturning a Credit Card Rejection.

  • Toni

    My credit score dropped 100 points because I had two items on my report in dispute..I asked them to take it out of dispute and that’s how my score dropped so low..so I decided to pay the items off in full.. One was closed credit card account and the other was a collection account..so last week my report was updated and now I’m in the high 700′s and mortgage approved..so your score will sky rocket when collection accounts are paid in full..

  • Alinger95

    Just got approved for a 20,000 car loan and they pulled a 708 for my credit score. To have that high of a credit score at only 18….. Great feeling!

    • http://www.credit.com/ Credit.com Credit Experts

      Glad to hear it — and good for you!

  • DFW EMS

    Ugh. The very idea that credit bureaus would use a system that actually disincentives paying off installment loans early is absolutely crazy. From the point of view of overall personal financial well-being, paying off any loan early will save on total interest paid over the life of a loan and that is a good thing. Any system which encourges consumers to do otherwise is, frankly, extremely unethical.

  • http://www.credit.com/ Credit.com Credit Experts

    A “hard” credit inquiry (as when you apply for a credit card or loan) causes a small, temporary dip in credit scores. It shouldn’t hurt long term. You and your husband can get your credit scores for free with a Credit.com account. It’s also a good idea to check your free annual credit reports to make sure that information is accurate. When you’re ready to apply for a car loan to replace the one you have, find out what scores are acceptable for what interest rates, and be as close to certain as you can that you’ll be approved before you apply.

  • Seekingthetruth2014

    Does this lady get kick backs from the banks and credit card companies? If you can pay off your loan and save money on interest charges do it. Take the money that you would normally spend on the credit card and invest it. This talk about keeping loans open just to have a high credit score is really misleading. This is coming from someone with a credit score of 814, it does not matter it is nothing but a number, a scam put into place for banks to make money. I pay everything in cash now, if you can’t afford it, don’t buy it!!

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