If you’ve got a bit of extra cash, paying off a loan may seem like a good way to put it to use and show lenders that you’re financially responsible. While paying off a loan can certainly improve your financial situation, its effect on your credit is a little more complicated.
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Can you pay off a loan early?
Yes, you can pay most loans off before they’re actually due. While installment loans are defined by their fixed repayment schedules (which means you’ll usually pay them off on an agreed-upon date), you can generally step up the timetable if you want.
Types of loans you can pay off early
Here are examples of the different types of loans you can pay off early:
- Personal loans
- Car loans
- Student loans
- Debt consolidation loans
- Home equity loans
- Credit-builder loans
With that said, some lenders impose restrictions on when you can pay your loan back, so you won’t necessarily be able to take out a loan and then immediately pay it off. To be sure, check the terms of your loan agreement.
How does paying off a loan early affect your credit?
Paying off your loan won’t necessarily improve your credit. In fact, it could have the opposite effect. It’s very common to see your score take a dip right after you pay a loan off, especially if you’ve had the loan open (and have been paying down your balance) for a while.
Briefly, this is because most credit scoring models will give you a slight boost for having a loan that you’ve paid a significant portion of (but haven’t paid off completely).
To understand exactly what will happen to your credit when you pay off your loan early, you need to understand how loans affect your credit score in the first place.
How unpaid loans contribute to your credit score
All loans affect the five main factors used to calculate your credit score:
- Payment history: This is a record of how often you make your loan payments on time and whether you’ve ever missed a payment due date or defaulted on your loan.
- Amounts owed (credit utilization): This is your current loan balance and how much you owe now compared to the original amount you borrowed.
- Length of credit history: How long it’s been since you took out your loan and how your loan’s age compares to the age of the other accounts in your credit file.
- Credit mix: How many loans you have vs. how many other types of credit accounts you have.
- New credit: How recently you applied for your loan and how many credit checks (known as hard inquiries) you have from loan applications.
How paying off a loan will hurt your credit
There are several reasons why your credit score might drop after you pay off debt:
Your debt-to-credit ratio will increase
Having a low balance on your loan is a sign of responsible financial management. Paying off a loan could cause you to lose the benefit that this has for your credit score, particularly if you have other loans with high balances.
Your credit mix will be less diverse
Your credit mix refers to the diversity of your credit accounts. It’s best to have both installment credit (like loans) and revolving credit accounts (i.e., credit cards).
Open credit accounts are weighted more heavily in your credit mix than closed accounts. 3 Since loan accounts are considered closed once you make your final payment, paying off a loan could hurt your credit mix, particularly if it’s the only loan you currently have open.
The loan will eventually fall off your credit history
Like other types of credit, loans build up your payment history and credit age. Provided your credit accounts remain in good standing, the longer they stay on your credit file, the better.
Paying off a loan won’t immediately remove it from your report—closed accounts can remain for up to 10 years—so this won’t hurt you for a while.
However, paying your loan off earlier does mean it’ll fall off your report earlier, so while this won’t be responsible for a drop in your credit score in the short term, it’ll get in the way of your efforts to build credit and improve your credit score in the long run.
How paying off a loan will help your credit
The effects of paying off a loan aren’t all bad. Despite the small drop in your credit score, paying your loan off can actually improve your credit in a couple of ways, especially in the medium to long term.
Lowers your outstanding debt
The overall amount of debt you have is one of the factors that affect your credit score. While having a loan that’s mostly paid off is good for your score, having large, unpaid debts usually isn’t.
If you took out your loan relatively recently and haven’t made much progress on it yet, it’s possible that paying it off early will do more good than harm to your credit score, at least in some credit scoring models.
With that said, this applies to all of your credit accounts. If you have other debts, you may be able to give your credit a bigger boost by paying off credit card debt instead. Credit card debt is usually more harmful to your score (and tends to come with higher interest rates to boot).
Lower risk of default
To be clear, this won’t directly benefit your score. It’s a defensive measure that you can take if you’re worried you might accidentally damage your credit score at some point in the future.
Reasons to pay off a loan early
Even though there’s a chance your credit score may take a slight hit, there are several situations where paying off a loan early may be a good idea. Note that these situations aren’t mutually exclusive—more than one might apply to you.
1. You want to save money on interest
The less time you spend repaying your loan, the less you’ll pay in interest. This is just the nature of how interest rates work—all other things being equal, the more payments you make, the more you’ll pay overall.
The amount you’ll save in interest from paying off your loan ahead of schedule depends on several factors:
- The size of the loan
- Your interest rate
- How early you pay it off
For an exact number, use a loan prepayment calculator to find out your total repayment amount.
2. There’s no prepayment penalty
Since lenders make their money from the interest you pay them each month, paying off your loan early means they won’t make as much money.
To discourage you, they may impose a prepayment penalty for paying off some or all of your loan balance in one large sum.
Depending on your loan contract, this fee could end up outweighing any financial benefit you’d get from paying your loan off early. Review the terms of your loan agreement to find out the conditions for prepayment, or ask your loan provider for clarification.
If your lender has an early payoff penalty fee, check whether they allow you to make higher monthly payments instead. Some lenders allow debtors to pay off their loans early if they do so in small increments rather than in one lump sum. 4
3. You don’t have any credit card debt
If you have a mix of credit card and loan debt, think carefully about which debts to prioritize paying down. In particular, bear in mind these points:
- Credit cards usually have higher interest rates: Loans often have lower interest rates than credit cards, meaning that if your goal is to save money, paying down credit card debt may be more effective than paying off a loan early. 5
- Credit card debt has a greater effect on your credit score: FICO models put more weighting on the amount you owe on revolving accounts than loan accounts, so you’ll probably get a bigger credit score boost from paying down credit card debt. 6
- Credit card accounts don’t close when you pay off your debt: Loans are considered “closed” once you pay them off, which, as mentioned, has several downsides. Credit cards, on the other hand, stay open even with a $0 balance (as long as you still use the card occasionally so your lender doesn’t close it due to inactivity).
All things considered, it’s usually better to pay down your credit card debt than make extra payments on your loans.
4. You’re preparing to apply for a new loan
Paying off your current loans could be a good idea if you’re planning to take out a new loan in the near future. This is because, in addition to running a credit check, prospective lenders will evaluate your debt-to-income ratio, which is how much of your overall income is going toward your current debt obligations.
When you pay off a loan, your expected monthly contribution to the account goes down to $0. This could make lenders more inclined to approve you for a loan or offer you a larger loan amount because they’ll have more confidence in your ability to make your payments.