You might expect paying off your car loan to help your credit. It’s not as simple as it looks, though, and you should think carefully before making a move. Sometimes paying off that loan early is the right thing to do, but at other times it could hurt your finances and even hurt your credit score.
How Paying Off A Car Loan Early Could Impact Your Credit
There are several ways that paying off a car loan early could affect your credit:
- Your car loan is an open credit account. Open accounts can have a greater influence on your credit than closed accounts. Lenders want to know how you’re managing your payments now just as much as how you handled them in the past. An open account with regular, consistent on-time payments is an asset to your credit and closing it can reduce the positive impact of that record.
- One of the factors that determine the health of your credit is your credit mix. Lenders often prefer to see a balance of revolving credit (such as credit cards) and installment credit (such as a mortgage, student loan, or car loan). If you don’t have any other installment loans, closing your car loan could hurt your credit mix.
- The age of your credit history affects your credit. If your car loan is one of the older loans in your credit history, paying it off could reduce the average age of your accounts, and that could have an impact on your credit score.
- Credit utilization, a factor in many credit scoring models, works off your current available credit and not closed accounts. Once you close the loan, your credit utilization rate will be calculated based on your accounts that are still open, and that could affect your credit.
You should be particularly careful about paying a loan off early if you have a limited credit history with a relatively small number of accounts. If you have a thin credit file, reducing the number of open accounts will have a greater impact.
When Is It Better Not to Pay The Car Loan Early?
There are other situations where paying off a car loan early is just not the right move to make:
- Some car dealers offer low-interest or zero-interest promotional loans. These loans have great terms and let you take advantage of lower interest or payments over the life of the loan.
- Some car loans use flat interest rates. The lender calculates the interest over the projected life of the loan and the interest is fixed at that level. Compared to a loan with a variable interest rate, you may see this as a huge advantage.
- Some loans carry prepayment penalties. A loan with a prepayment penalty may still be worth paying off early, but you’ll have to include that penalty when you calculate the costs and benefits of prepayment.
- If you have only a few payments left on a loan, you’re not likely to significantly reduce your interest by paying the loan early. You may be better off just paying the loan on schedule.
If you’re considering paying a car loan early, stop and think about other things you could do with that money. For example, credit card balances average 17.75% interest; car loans average 4.75%. If you have a credit card balance or another higher-interest loan, consider paying that off first.
Furthermore, think about if you have an emergency fund to fall back on if you face a job loss, medical expenses, or another crisis? Paying off a car loan means that money is now unavailable, unlike when you save it or pay off a credit card.
Finally, If you have an emergency fund and your credit cards are paid up, it might be time to use that money to begin investing. Money can sometimes work better for you when you ride out manageable debt with regular payments.
When Might Paying a Car Loan Be Beneficial?
Sometimes it’s a good idea to pay a car loan off early. You may consider doing so in the following situations:
- If your car loan carries a high-interest rate, paying the loan early could generate enough savings to be worth a short-term impact to your credit score.
- If your car loan has a high-interest rate, but you need an installment loan in your credit mix, you may want to consider refinancing the loan. This will pay off the car loan, but leave you with an open loan that may have more favorable rates.
- At some point in the life of your car loan you may owe more than the car is worth. This can make it difficult to refinance or to sell the car at a profit. Paying off a car loan early can prevent you from “going upside down” on your car loan.
- If you wish to sell your vehicle to a private buyer, you may need to pay off your loan so you’ll have an unencumbered title to the car.
In each of these cases, you’ll need to weigh what you expect to gain against the potential impact on your credit. Consider your immediate financial plans. If you’re in a position where a small change in your credit could have a major impact on a financial decision (like negotiating a mortgage), it might be a good idea to delay paying off your car loan until after that’s settled.
Should You Pay the Loan Off Early Or Not?
There’s no universal right answer to that question. Your answer will depend on your loan, your credit history, and your financial situation.
Consider the interest rate on your loan and the time you have left to pay. Calculate what you’d save by paying the loan early. Be sure to check for precomputed interest and prepayment penalties.
Consider your credit mix and your credit history and anticipate the impact that early payment could have on your credit. If you’re not familiar with your credit report, order copies today, and study them. Knowing what’s in your credit report can help you make more informed decisions.
Balance the money you expect to save against any possible damage to your credit, consider other financial impacts of early payment, think about other things you might be able to with that money, and you’ll be in a position to make an informed and confident decision.