If you’re like most people, you’re making monthly payments to some type of installment loan. Sure, the last day you make the payment will be a joyous occasion, but should you pay it off sooner? Does paying off your loan earlier than expected impact your credit score? There is no short answer when it comes to this question. Here is how paying off your installment loan at a steady rate will create a better credit score.
Getting a loan affects your credit score.
Getting an installment loan is an investment of time and money. You have to make steady payments to the account for a period of time that could be just a few months or up to several years. However, getting this type of loan diversifies the type of debt you accrue and pay. This diversification reflects better on your credit score if you pay back the debt on time. This type of debt makes up for around 15% of the average person’s Equifax Credit Score.
Making payments on time every month at a steady rate shows a history of reliability. This consistency is extremely important for anyone who is trying to increase their overall credit score. It can turn no credit into good credit, or bad credit into better credit. Approximately 35% of a person’s score is based on their payment history. A steady, secure payment history fortifies a healthy credit score.
Paying it off early won’t earn you additional points.
You may think that if you pay off an installment loan, you’ll have a better credit score. This is less debt, and less debt is good, right? Wrong. Paying off an installment loan isn’t like paying off credit card debt. Your monthly payments are actually raising your credit score. However paying the loan off will close the account, which will decrease your total amount of available credit. This can actually have a negative impact on your credit score.
Why does it lower your credit score? Your credit score drops because your utilization ratio has risen. This is the percentage of a consumer’s available credit that they have used. This is determined by the amount of outstanding balances on all credit cards divided buy the sum of each limit from the cards. So, let’s say you have a $15,000 car loan that has a $7,000 balance left to pay. If you pay it in one payment, your debt load will drop by $7,000, sure, but your available credit will drop by $15,000. Overall, this will raise your utilization ratio, which is not good for your credit score.
Plus, keep in mind that some companies will charge you a fee if you choose to pay your loan off early. This is because the company is likely to lose money on interest that would otherwise accrue on the account. The only way to determine this is by looking at your contract.
Just pay it off on time.
The best way to raise your credit score and accumulate points while you pay off your installment loan is by making all of your payments on time. Make every payment in full on the date it is due. Paying late can hurt your credit just like paying it off early. If you have the option, consider setting up an “automated bill pay” system. This means that the full monthly payment will be taken out of your bank account when it’s due. Most banks offer this service as well as many loan companies.
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