There are lots of reasons for paying off a car loan early. Once you’ve paid off your debt, you’ll own your own car! You’ll be free of your obligation to the lender, and you’ll pocket hundreds of extra dollars every month. And successfully paying off your auto loan will boost your credit score.
Or will it? Generally speaking, paying off debts will usually improve your credit score. But credit is complicated. To find out if paying off your loan will boost your score, we’ll have to take a closer look at how it affected your credit in the first place.
Let’s start with some background. What determines your credit score? How does an auto loan affect your score? And how will that change when the loan is paid off?
What determines your credit score?
1) Payment history
The most important factor in determining your credit score is your payment history. The more on-time payments you make, the better. Just one missed payment could tank your score.
Car loans are great for building an on-time payment record as long as you do, in fact, make your payments on time. This factor alone will boost your score more than anything else. Luckily, on-time payments will stay on your record for 10 years after you close your account. Even if you do pay off a car loan early, you’ll still be able to take advantage of this on-time payment boost for the ensuing decade.
2) Amount owed
The amount you still owe on your debt will also affect your credit score. High levels of debt will lower your credit score, and having low (or no) balances owed will boost it.
However, not all types of debt are treated the same. Having a high balance on your credit cards can be much more damaging than having a high balance on your car loan. Still, the more you owe (and the longer you owe it), the more it will hurt your credit score.
3) Average age of your credit history
Creditors like to see that you have a long history of managing your debt well. They measure this by taking the average age of all your open accounts.
For example, let’s say you’ve had a credit card for 10 years and a car loan for two years. Your average account age would be six years. In general, creditors like to see an average account age of more than five years.
This factor is of medium importance in determining your credit score. It’s still important, but not as much as having a consistent payment history and low balances owed.
4) Range of credit types
All types of credit—auto loans, student loans, credit cards, etc…—operate differently. That’s why creditors like to see that you can manage a diverse range of open accounts.
As such, having an active auto loan can be good—it adds one more type of credit to your set. And once you pay this loan off, you’ll have one less account type. However, this is one of the least important factors in determining your credit score, so it should not dissuade you from paying off your debt.
How will paying off a car loan affect your credit score?
Taking out an auto loan affects all four determining factors of your credit score. It augments your payment history, raises your total amount owed, adds another figure to your average credit age, and contributes an additional credit type to your portfolio.
Because keeping your auto loan can add or detract from your credit score, it’s hard to say with certainty that paying off a car loan will boost it. It all depends on your situation.
For example, if paying off a car loan bumps your average account age from four to six, it could boost your score. But if paying off a car loan decreases your average account age, it could lower your score by a few points.
On the other hand, if pay off a large amount in its entirety, you could see a bump in your credit simply from owing less on your accounts.
In short, how your auto loan payment affects your credit depends greatly on your context. Luckily, there’s no need to overthink it. Whether paying off your loan boosts or lowers your credit score, it will likely only be a mild change.
So should you pay off your car loan early?
It’s almost never a good idea to hold onto debt simply for the sake of boosting your credit score by a few points.
There are exceptions to this rule. Let’s say you’re getting ready to apply for a big loan and your credit score is just above the threshold for good credit (700-710). In this precarious position, you may want to wait until after you’re approved to rock the boat.
In most situations, though, the sooner you eliminate your debts, the better.
Managing your auto loan can be hard, but it’s crucial that you make your payments on time if you want a healthy credit score. If you’re struggling to make payments, it might be time to make your monthly payments more affordable by refinancing your auto loan.