In the world of personal finance, the credit score reigns supreme. Financial providers use it to determine whether you will handle credit properly, insurance companies use it to determine the risk of covering you, and some landlords use it to see if you qualify for an apartment. Because credit scores are so important, it is in your best interest to know how different financial decisions may affect your score. One decision that can impact your score is paying off a loan early.
How Credit Accounts Impact Your Credit Score
Let’s start with a brief explanation of how different credit accounts impact your score. There are five aspects that your credit score is built upon: payment history, debt utilization, length of credit history, new credit, and the types of credit used. A new loan will impact all five at once and lower your score until your first payment has been posted to the credit reporting agencies. Each payment after that will allow your score to grow by showing a history of on-time payments, utilization of an installment credit account, and, as the loan ages, the impact from opening a new account fades.
Credit cards boost or lower your score every month through on-time payments, length of credit history, and debt utilization. The key element here is your debt utilization ratio. If you carry a balance in excess of thirty percent of the credit limit on your cards, your score will suffer. If you maintain a balance that is less than thirty percent, your score will move higher.
Pay A Loan Off Early
Paying off a loan early can both hurt and help your credit score. The help is by lowering your overall debt utilization amount. Debt utilization accounts for nearly one-third of your credit score, so you can see a positive boost from lowering it to be sure. The boost is mainly created by having low credit card balances, not installment loans. The hindrance to your credit score will be in the length of your credit history. Once you pay off a loan, it no longer adds to that length.
One final thought to consider when you are kicking around the idea of paying off a loan early is: What are your future plans in regards to new loans? If you want to apply for any type of loan, lenders are going to look at your debt-to-income ratio or DTI. If your DTI is more than 35 percent of your gross monthly income, you will struggle to get the loan you want. Paying a loan off early will immediately lower your DTI; therefore boosting your future loan opportunities.
Personally, I am for paying off every loan early. This will keep your DTI at its lowest possible point and keep cash free when you need it. If you are worried about the length of your credit history, the best way to boost it is to obtain a credit card and keep that account open.