Does Paying Off Loans Early Affect Your Credit Rating?

Paying off your loan early can save you money and free up some of your monthly cash flow. However, if you are rushing to get rid of the loan in hopes of improving your credit, you might want to slow down. Simply paying loans off early, regardless of the type, will not raise your credit score. Depending on your credit history and goals, however, closing the account may help you in other ways.

Limited Credit

You do not receive additional points on your credit score for satisfying your loan agreement ahead of schedule. If you have limited credit history, it is best to leave the account open until you are approved for other accounts. According to Experian, a major credit reporting bureau, open and active accounts are scored higher than closed accounts. Paying off the loan early can save you some money in interest, but it does not help your credit. The type of credit you have also affects your score. A mixture of credit, including both installment and revolving accounts, tends to score higher than having only one type of credit.

Established Credit

If you already have an established credit history, paying off your loan early may help you in other ways. When you pay off your loan, you have one less bill to pay each month. Your debt-to-income ratio is the percentage of your gross monthly income applied towards debt. Although your debt-to-income ratio is not a credit score factor, lenders typically assess the amount of debt you have to ensure you are able to afford taking on a new account. If you have too much debt, the lender may see you as a risk.

Credit Utilization

Instead of paying off your loan and closing the account, consider paying down the balance. Credit utilization, sometimes called debt utilization, is a factor in 30 percent of your FICO score. Each individual account is scored based on the percentage of available credit compared to the limit. The accounts are scored separately and together to determine the total amount of credit you are utilizing. FICO does not reveal an exact ideal number, but it is best to keep it as low as possible. If you have high credit card balances or a new mortgage, paying off a large portion of your personal or auto loan can help lower the ratio.

Considerations

Regardless of whether you pay off the loan early, make sure all payments are made on time. Your payment history accounts for 35 percent of your FICO credit score. If you decide to pay off your loan, it will still remain on your report for seven years as a closed account that was paid as agreed. Watch out for prepayment penalties if you decide to pay off the loan early. Some lenders charge a fee that equals a certain percentage of the interest remaining on the loan.