Does Paying Off an Auto Loan Raise Credit Score?

Posted by Mayank on August 19, 2013 in Personal Finance

It may be tempting to pay off your auto loan if you have available cash. While it does make common sense to pay off your car loan when you have cash surplus, unfortunately the way our finance market works – it may not always be a good decision to do so. What you need to do is to study the impact of paying off auto loan and then take an informed decision.

Credit Score is a representation of how you’re doing with credit or debt. So, if you don’t have a credit or debt, you will have a poor score. But if you have high debt – that isn’t good either. So, the need is to find the soft spot, which would make taking credit helpful and work towards increasing your credit score.

Does Paying Off an Auto Loan Raise Credit Score?

Type of loan

Paying off an auto loan might actually hurt your credit score. I’ll explain you why, let me explain to you two important terms to classify your loan – (i) Revolving accounts (credit cards) and (ii) installment loan accounts (i.e. a mortgage, student loan). Paying an installment loan off early won’t earn you any substantial credit score points and in fact, keeping them open for the life of the loan may actually be a better strategy for your credit score. Let’s take a look.

Credit cards are revolving accounts because you revolve a balance from month to month as part of the terms of the agreement. And even if you pay off the balance, the account stays open and remains open until you close that credit card account. A credit card with a zero or a low balance and a high credit limit is very good for your credit score. Having multiples of such credit cards will push your credit score higher.

auto loans

An installment loan is a loan with a set number of scheduled payments spread over a pre-defined period of time. When you pay off an installment loan you’ve essentially fulfilled your part of the loan obligation — the balance is brought to $0 and the account is closed. Due to this very different nature and definitions of two accounts – paying off an installment loan doesn’t have as large of an impact because the amount of debt on individual installment accounts isn’t as significant a factor in your credit score as credit utilization is.

Age of close accounts

As closed, inactive accounts age, they mean less and less for your credit scores. Credit scoring models typically weigh open, active accounts more heavily than closed accounts. So, when it comes to installment loans, paying them off will not have a huge impact on your credit score – it has been reported that there would be a difference of +5 when you close your car loan or auto loan. In fact, continuous timely payments on an installment loan each month will have a greater impact on your credit score as compared to paying off your auto loan because it lets you demonstrate the ability to timely payments.

Another variable in calculating credit scores is the length of your credit history. The longer you’ve had open accounts the better. Paying off an installment loan shortens the average length of your credit account history and works against you. Closed accounts do stay on your credit history—but for a limited period of time only. If there are any late payments, the account history lingers for 7 years—and if not, it stays in your file for 10 years.


Number of Accounts

Credit score bureaus love to see a number of different types of credit accounts. This is to represent a real life scenario, where a person keeps adding different kinds of loans – student loan, auto loan, home loan, credit card loan, personal loans etc. Having multiple loan accounts gives you an opportunity to show that you’re able to manage different types of credit and it’s good for your credit score.

Total Number of Accounts with Balance

The number of accounts with balances is one of the major factors in your credit score. When you pay off a loan you’ll have one less account with a balance, which will do good to your credit score.

Bottomline:

If you’re planning to pay off your auto loan to save money on interest – you should definitely do so, especially if you have a good credit. Just make sure that there isn’t a pre-payment penalty which would negate your savings on interest. To achieve excellent credit you need to show positive history with both installment and revolving credit accounts.

However, if you’re planning to close your auto loan to improve credit score, you should ignore the thought because at best you will see a +5 increase in your credit score.

Related Posts Plugin for WordPress, Blogger...

Comments on this entry are closed.