Does Paying Off a Loan Early Hurt Credit?
Can something that seems as positive as paying off a loan early really be a negative thing? Sometimes — here’s why.
February 28, 2022
When you have a loan, you might find yourself daydreaming about finally paying it off — but that fantasy can lead to all kinds of questions and fears. Does paying off a loan early hurt your credit? Should you clear your debt as quickly as possible or follow the life of the loan to its end?
We know it’s a frustrating answer, but the truth is that it depends on your circumstances and the kinds of loan(s) you have. To build a clearer picture, let’s run through how loans work and how they can impact your credit score.
How do credit scores work?
To determine the impact of an early payoff on your credit, you need to understand how scoring agencies determine credit scores in the first place.
The following factors influence your FICO Score (a leading credit scoring model):
Payment history: Such as making on-time payments and avoiding late payments
Amounts owed: The percentage of your available credit you use
Length of credit history: The age of your open credit accounts
Credit mix: The variety of types of credit you have
New credit: Not opening too many new accounts too quickly
You might already be able to guess how paying off your loan early could impact some of these factors and, therefore, alter your score. However, this will vary depending on the type of loan you have.
Revolving vs. installment loans
There are a few different types of loans, which have different factors at play that could impact your credit score. There are two main types of loans to be aware of:
Revolving accounts: Open-ended loans that let you borrow up to a credit limit and carry the balance from one month to the next, like credit cards or lines of credit
Installment loans: Loans with a specified duration that you pay back in installments over a fixed schedule, including home loans, student loans, auto loans and personal loans
If you carry both revolving credit and installment loan debt, you might not notice the differences between them — especially if you pay off your entire credit card balance each month. However, the ways they influence your credit score are very different.
Credit cards are revolving accounts, meaning you have a choice between holding a continuous balance or paying off your balance in full before the payment due date each month.
As long as you don’t borrow more than your credit limit and you meet your minimum payments, there’s no obligation to pay the debt off within a specific timeframe (although you’ll accrue interest and hurt your credit score).
Paying credit card debt off “early” usually means paying it off before the due date. Crucially, whatever you do, your account will remain open unless you choose to close it, which makes a huge difference for your credit report.
With installment loans, borrowers can’t carry their balance from one month to another. You agree to certain loan terms when you sign up for an installment loan. For example, you might take out a 30-year mortgage worth $200,000 with an APR of 3%. Lenders then use these numbers to figure out your monthly payments.
When you’ve paid off the loan principal of $200,000 plus the interest accrued along the way, your account will close. You may be able to pay this off early, but it’ll have a greater impact on your credit score because the account will close.
So, does paying off a loan early hurt credit?
We’ve already hinted at how the mechanisms behind revolving accounts and installment loans can affect your credit. Still, we haven’t given a definitive answer to whether paying off a loan early hurts credit and why.
Let's take a look now.
How revolving accounts affect your credit
This one is quick and easy. Because your credit card account will always stay open unless you close it, paying your balance early won’t affect the length of your credit history or your credit mix. Paying off your balance will boost your payment history.
The only other credit score factor at play is the amounts owed. Credit bureaus receive information about your balance at the end of your billing cycle, so making some extra payments before this comes around can make it seem like you’re using a lower percentage of your available credit. This lowers your credit utilization rate, which can improve your credit score.
However, it’s best not to pay the full balance off before the billing cycle ends. If you do, the credit card bureaus will think you’re not using the card and you won’t benefit from your good credit card management.
How installment loans affect your credit
Installment loans are more complex. Although credit scoring agencies don’t deem paying off your loan early to be a “bad thing,” it can negatively affect some of the factors that affect your score.
The first thing you have to consider is that closing your account could affect the length of your credit history because only active accounts are included in the calculation. Similarly, closing your account could affect your credit mix if it’s the only installment loan you have. These aspects don’t affect your credit score as much as payment history and amounts owed, but they’re still worth keeping in mind.
Plus, regularly making your interest payments as part of your installment loan schedule can help you to demonstrate a good payment history. However, paying off your loan early wouldn’t give you a chance to build up this positive history. Therefore, the net effect can end up being negative rather than positive.
Closed accounts still show up on your credit report for up to 10 years, so you’ll have something to show for your past payment history — but active accounts are given more weight.
Should you pay off your installment loan early?
Figuring out whether paying off a loan early is the right decision will primarily come down to your financial situation.
Paying off a loan early can improve your debt-to-income ratio (total debt divided by total income), which is something lenders consider when approving mortgages.
You should also think about the APR your lender is charging you. The higher the number, the more money you’ll save by paying a loan off early. So, you may decide that saving on interest payments is more helpful than the small hit to your credit score is harmful. Maybe you’d prefer to use that money to build up an emergency fund, for instance. Doing so could save your credit score in the future if you fall into troubled times.
So, when should you avoid paying off a loan early? If you’re lucky enough to have a 0% interest loan, it’s almost certainly better to keep the account open for its full duration. Also, in some cases, paying off a loan early could result in prepayment penalties, so this is something you should always check for. These penalties are common for auto loans and home loans, but they never apply to student loans.
Knowledge is power when paying off a loan
As you can see, personal finances can get complex. Two people doing the same thing (paying off their loans early) can end up with very different outcomes depending on their circumstances, so make sure you understand your unique situation before you take action.
But regardless of your situation, staying on top of your credit card debt is always a positive move. To help with that, the Tally† manages credit card payments on your behalf and consolidates your higher-interest credit card debt into a lower-interest line of credit.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.