It may be tempting to pay off a loan if you have the cash ready - but how will it affect your credit score? Money Girl explains.
A Money Girl podcast listener named Randy P. asks:
I have enough cash to pay off my car loan which is about $12,000. Does paying off a loan early raise my credit score—or is it better to just keep making monthly payments according to the original loan schedule?
Though reducing debt can raise your credit scores, you also need to use credit accounts in order to maintain good credit.
Here are 3 reasons why keeping an installment loan—such as a card loan or mortgage—and paying it off according to the loan term can benefit your credit:
Reason #1: The account will be closed.
Paying off an installment loan means that the account will be closed right away. As closed, inactive accounts age, they mean less and less for your credit scores. Credit scoring models typically weigh open, active accounts more heavily than closed accounts.
Therefore, continuing to make timely payments on an installment loan each month, instead of paying it off early, is a powerful way to demonstrate that you know how to use credit responsibly.
Reason #2: Your credit history is shortened.
Another variable in calculating credit scores is the length of your credit history. The longer you’ve had open accounts the better. Paying off an installment loan shortens the average length of your credit account history and works against you.
Closed accounts do stay on your credit history—but for a limited period of time only. If there are any late payments, the account history lingers for 7 years—and if not, it stays in your file for 10 years.
Reason #3: You need a mix of credit account types.
To achieve excellent credit you need to show positive history with both installment and revolving credit accounts—such as credit cards and lines of credit.
Since revolving accounts have credit limits, paying them down can really boost your credit scores. Read more (or listen to the podcast) about the optimal balance to maintain on a credit card in Credit Utilization—What It Means for Your Credit Score.
Does Paying Off a Loan Raise Credit Scores?
For the 3 reasons above, paying off an installment loan ahead of time doesn’t outweigh the benefits to your credit scores that you get from paying it off over time.
However, you may still want to consider paying off a loan early—especially if you already have good credit. Getting rid of a debt saves you money on interest, as long as there isn’t a prepayment penalty. I cover this topic in more detail in the following articles and podcasts:
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Looking for smart strategies to raise your credit score fast? Download the Credit Score Survival Kit. This free multimedia resource will help you fast-track your credit success and show you how to monitor and repair your credit report and credit scores for free.
Other Articles and Resources You Might Like:
What to Know Before You Cancel a Credit Card
How to Get Credit With No or Bad Credit
Consolidate Credit Card Debt and Save Money
Credit Score FAQ (VIDEO)
Where to Get Your Free Credit Scores
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