To analyze the information from consumer credit reports and produce credit scores, credit-scoring companies use proprietary models. Credit-scoring models typically take into account the same fundamental variables (in this order of significance) even though it can vary based on the organization that calculates it:
- Your financial history
- Totals of what you owe
- Duration of time since last using credit
- Your credit mix
- Your number of new credit accounts or applications
These elements are taken into account by lenders and credit agencies as indicators of your past credit management skills and your propensity for managing new credit accounts. A higher credit score can be attributed to a long history of on-time credit payments, a smaller overall amount of debt, and a healthy mix of different credit types.
How loan repayment can impact credit scores
It is possible (but not definite) that your credit score could drop a bit immediately after you pay off a loan. That’s because paying off a debt affects some of those credit score factors we just discussed.
Paying off the loan also reduces your total amount of available credit, which in turn affects your credit utilization ratio — the comparison of how much credit you use to how much total credit you have available.
If your objective behind paying off the loan early is to give yourself breathing room to take on a bigger, more significant debt like a mortgage, you may not want your credit score to drop right now. It might make more sense to put your money toward paying off any credit card or student loan debt you may have.
Why it still may be a good idea to pay off your loan early
Now, you may be thinking, “Bummer! Guess I’ll keep my loan.” But despite the potential short-term effect on your credit score, there are some very good reasons to pay off your loan early.
I already mentioned one — interest savings. Paying off your loan just three months into your repayment term means you save nine months’ worth of interest. On a $20,000 loan, that amount could be significant, depending on your interest rate.
Then there’s the advantage of eliminating a monthly payment that’s likely north of $1,000. Imagine keeping that amount of money in your pocket for the rest of the year. What could you do with it? Pay down other higher-interest debt? Build an emergency fund? Increase your retirement savings?
Finally, there’s the psychological boost of paying off a debt. It’s a satisfying feeling. If avoiding a temporary hit to your credit score isn’t a priority right now, and you don’t need the money for anything else, go ahead and pay off your loan early.
Information By Fox News