The question of whether or not to pay off your car loan early may seem obvious, but the answer is more complicated than it first appears. In some cases, paying off your car loan early can negatively affect your credit score.
Early car loan payback can lower your credit since open, positive accounts affect your score more than closed ones do, but there are other things to take into account as well. Before you rush to write that last check to your lender, heres what you need to know.
The answer to this question is not a simple yes or no. While paying off a car loan early can have a positive impact on your credit score in the long run, it’s important to understand the potential short-term effects and other factors that can influence your credit score.
Short-Term Impact: A Potential Dip
Paying off your auto loan early can actually lower your credit score a little bit in the short term. This is due to the fact that terminating a credit account can lower your credit mix and overall credit utilization ratio, even if it has been paid off in full.
Your credit mix refers to the different types of credit accounts you have open such as credit cards, installment loans (like car loans) and lines of credit. Having a diverse mix of credit accounts shows lenders that you can responsibly manage different types of debt.
Your credit utilization ratio is the amount of credit you’re using compared to your total available credit. When you pay off your car loan, you’re essentially closing a credit line, which can increase your credit utilization ratio if you don’t have other open credit accounts. A higher credit utilization ratio can negatively impact your credit score
Long-Term Benefits: Building a Stronger Credit Profile
However, the long-term benefits of paying off your car loan early can outweigh the short-term dip in your credit score. Here’s how:
- Improved Debt-to-Income Ratio: Paying off your car loan reduces your monthly debt obligations, which can significantly improve your debt-to-income ratio (DTI). Your DTI is the percentage of your gross monthly income that goes toward debt payments. A lower DTI makes you a more attractive borrower to lenders, as it indicates that you have more disposable income to handle additional debt.
- Reduced Interest Payments: Paying off your car loan early saves you money on interest charges. This can free up additional funds that you can use to pay down other debts, build your savings, or invest for the future.
- Positive Payment History: By making all your car loan payments on time, you demonstrate a positive payment history, which is a crucial factor in your credit score.
Other Factors to Consider
Even though paying off your auto loan early can help you establish credit, you should be aware of other variables that may have an effect on your credit score, such as:
- Credit Score Starting Point: If you have a low credit score to begin with, paying off your car loan early may not have a significant impact on your score. In this case, it might be more beneficial to focus on paying down other high-interest debts first.
- Prepayment Penalties: Some lenders may charge a prepayment penalty if you pay off your car loan early. Be sure to check your loan agreement before making any extra payments.
- Overall Financial Situation: Make sure that paying off your car loan early won’t negatively impact your overall financial situation. Consider other financial goals you may have, such as saving for a down payment on a house or investing for retirement.
The Bottom Line: A Smart Strategy for Building Credit
In general, paying off your auto loan early can be a wise move to establish credit, particularly if you can afford to make additional payments without endangering your ability to make ends meet and have a high credit score to begin with. Before choosing a choice, it’s crucial to consider the possible short- and long-term effects on your credit score.
Additional Resources:
- Bankrate: Should You Pay Off Your Car Loan Early?
- Credit.com: Paying Off a Car Loan Early: Does It Affect Your Credit Score?
Frequently Asked Questions
Q: Does paying off a car loan early build credit faster?
A: Not necessarily. While paying off your car loan early can improve your credit score in the long run, it’s important to remember that it can also cause a temporary dip in your score.
Is it preferable to invest the money or pay off a car loan early?
A: This depends on your individual financial situation and goals. If you have high-interest debt, it may be more beneficial to pay that off first. However, if you have a low interest rate on your car loan and have other financial goals, such as investing for retirement, it may be better to invest the money instead.
Q: What other ways can I build credit?
A: There are many ways to build credit, including:
- Making all your bill payments on time
- Keeping your credit card balances low
- Becoming an authorized user on a credit card with good credit history
- Taking out a small personal loan and making payments on time
- Using a secured credit card
When Is It a Good Idea to Pay Off Your Car Loan Early?
There are some situations when paying off your car loan early may be a smart move:
- If you have a high interest auto loan: Over the course of the loan, you will pay a significant amount of interest if your auto loan has a 60-, 72-, or even 84-month term. Early loan repayment can lower the total amount of interest you pay. Make sure your lender doesn’t impose a prepayment penalty before proceeding to ensure early loan repayment. (If you have a loan with precomputed interest, you must pay the precomputed interest even if you pay it off early because the total amount of interest was determined and fixed at the beginning of the loan. An alternative to paying off an auto loan early is to refinance it for one with a lower interest rate. Refinancing can lower your payments if your credit score has increased or interest rates have significantly decreased since you purchased the car, and your credit score will still be positively impacted if you make those payments on time.
- When you should raise your debt-to-income ratio: When determining whether to grant you credit, some lenders take into account your debt-to-income (DTI) ratio, which is the total amount of money you owe each month divided by the total amount of money you make. Lenders typically want to see a DTI of 2043 percent or less, but many would rather see ratios below 2031 percent. (Learn more about calculating your debt-to-income ratio. (If you intend to apply for a home mortgage soon but your debt-to-income ratio (DTI) is higher than what most lenders prefer to see, paying off your auto loan early may increase your chances of being approved.
- If you have a long credit history with a variety of credit types, paying off your car loan early should only result in a brief decline in your credit score. When you have additional open accounts: Do you have a lot of other credit accounts and a good credit mix (such as a mortgage, a student loan, and several credit cards)?
How Paying Off Your Car Debt Early Can Hurt Your Credit
Your credit score may decrease slightly whenever you make a significant change to your credit history, such as repaying a loan. This decline should only last a short while if there are no adverse items on your credit history; in a few months, your credit scores should rise once more. Your auto loan will stay on your credit report for ten years after it is paid off and the account is closed, and as long as you have always made your payments on time, the loan will continue to have a good impact on your credit history.
Although closed credit accounts still have an impact on your credit score, the impact is greater for open, positive credit accounts than for closed ones, so what’s the deal with paying off your car loan early? Thats because open accounts show lenders how well youre managing your credit right now—not in the past.
Keeping a car loan open rather than paying it off could be more beneficial if you’re trying to build credit or raise your credit score. For instance, obtaining a car loan will increase the number of credit accounts you have, which will help to establish your credit history, if you currently have a thin credit file (i.e., few credit accounts). A car loan also helps to improve your credit mix by diversifying the types of credit you have. Your credit mix can be improved by having both installment credit (loans with a fixed monthly payment) and revolving credit (credit cards that allow you to carry a balance). This will raise your credit score.