Credible takeaways
- The impact that paying off a loan will have on your credit score depends on your overall financial picture.
- You may see a slight drop in your credit score after paying off a loan.
- You could see your credit score rise after paying off credit card debt.
- Paying off a loan can free up funds for other expenses and financial goals, which could make it easier to access credit in the future.
Loans are common ways to pay for major expenses such as a car or home, or to consolidate debt. When you pay your loan on time each month, it generally reflects positively on your credit report, since payment history makes up 35% of your FICO score.
But what happens after you pay off a loan completely? Will it help your credit or hurt it? Generally speaking, it depends on your financial situation.
How paying off a loan affects your credit
It’s challenging to predict the impact that paying off a loan will have on your credit, since everyone’s situation is different, and it depends on the type of loan you're paying off. In some cases, paying off a mortgage, car loan, or personal loan may ding your credit score. In others, it may barely impact your score at all. On the other hand, paying off a credit card can help your score, as long as you keep the credit card open.
Here are a few credit factors that may be impacted by paying off a loan:
- Credit utilization: How much credit you're currently using relative to the credit available to you can contribute up to 30% of your credit score. By paying off certain types of accounts, like credit cards, you can increase your available credit, thereby reducing your credit utilization, which can increase your score.
- Credit mix: Creditors like to see that you can manage different types of credit, such as loans and credit cards. If you pay off your only loan, such as an auto loan or personal loan, it may negatively impact your score, as it would decrease the diversity of your credit mix. Credit mix makes up 10% of your FICO score.
- Length of credit history: When you pay off a loan, the lender usually closes the account. This stops the account from continuing to “age,” which may impact the length of your credit history. The length of your credit history makes up 15% of your credit score.
Beyond potential credit impacts, there are other factors to consider when deciding whether or not to pay off a loan. For example, paying off a loan frees up money for other purposes and saves you interest.
Does paying off a loan early help your credit?
Whether paying off loans, such as a personal loan or auto loan, early will help your credit heavily depends on your overall credit profile and the type of account you're paying off.
Pros of paying off a loan for your credit
- Lowers your overall debt: Paying off debt is generally a good idea, as it can free up money for other goals and reduce financial stress. It also lowers your debt-to-income ratio (DTI), which can help you qualify for mortgages and other types of loans.
- Increases your available credit: If you can keep the account open, like with a credit card or line of credit, the credit available to you will increase when you pay off your balance. This lowers your credit utilization which can improve your credit score.
- Shows responsible credit history: Paying off a loan looks good to lenders, as it helps indicate you are a responsible borrower who repays their debts. Closed loan accounts can remain on your credit report for 7 to 10 years.
Cons of paying off a loan for your credit
- Your credit score may drop: Your credit could take a hit after you pay off an installment loan, especially if you don’t have other loans on your report, as it affects your overall credit mix. However, the impact on your credit score is usually temporary.
- Chance of prepayment penalties (rare): Very few lenders charge prepayment fees if you pay off a loan early. But it’s still worth reviewing your loan terms to make sure there is no penalty that could cut into any interest savings from paying early.
Learn More: Should I Pay Off Debt or Save?
Simple strategies for paying off loans
Here are some strategies to consider for paying off debt. Just note that reducing the amount you owe on your credit cards could have a more positive impact on your credit score (and budget) than paying off an installment loan early.
Budgeting
Making a budget can help you allocate more of your income toward debt repayment, so you can make progress faster and minimize the amount you pay in interest. It can also help you save money and break free from a cycle of debt. Having money set aside for emergencies makes it less likely you’ll need to turn to credit cards and other types of debt to pay for unexpected expenses. There are many popular budgeting apps and tools available, but if you prefer a more traditional paper budget or spreadsheet, these are also an option.
Debt snowball or avalanche method
Two of the best strategies for paying off debt are the debt snowball and avalanche methods. The debt snowball method involves prioritizing paying off your smallest debt first, while making all other minimum payments. Once the smallest balance has been paid off, add the amount you were putting toward it to the minimum payment on the next-smallest balance, and so on. By prioritizing the smaller balances first, you’ll likely see progress faster, which can help boost motivation.
The debt avalanche method works similarly, but involves first focusing your attention on the debt with the highest interest rate. Using the avalanche method can help reduce the total amount of interest you pay on your debts, but it may take longer to see initial results.
Loan refinancing
Sometimes, you may want to replace a high-interest loan with a lower-interest one, instead of paying it off entirely. This is common, for example, with mortgages and personal loans. In this case, you'd apply for a new loan and use it to pay off the old one, thereby reducing your interest rate and monthly payments. The application for new credit and the closing of the old loan could initially lower your score, but as you develop a positive payment history on the new loan, it should improve.
Learn More: How To Refinance a Personal Loan
Does paying off a loan help credit FAQ
Should I pay off a loan or keep making payments?
If you have the means, paying off a loan is generally a good idea to save on interest and free up money for other financial goals. Paying off a loan can also help lower your DTI, which may improve your approval odds for another credit product down the line. But if you have any credit card balances, it's generally best to pay those off first. This is because interest rates tend to be higher on credit cards than on many installment loans, and you can increase your available credit.
How long does it take for my credit score to improve after paying off a loan?
Generally speaking, any negative effects on your credit score after paying off a loan are likely to be temporary. If you manage your credit responsibly by paying your accounts on time, keeping your utilization low, and limiting hard inquiries, your score should improve with time.
Is paying off a loan a good way to build credit?
It’s challenging to predict exactly what paying off a loan will do to your credit. Paying off a loan may lower your credit score if it impacts the length of your credit history and overall credit mix. But if you pay off revolving debt, like credit cards or a personal line of credit, it could very quickly boost your credit score as it reduces your credit utilization.
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