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When it comes to paying off debt, several people say that paying off your balance as soon as possible can help you save some money in the long run. And this is typically the case. For instance, you'll save on interest payments if you pay off your total credit card balance.
Most of the time, the longer you take to pay back a loan or any other debt, the more interest you'll pay over the duration of the loan. In light of this, paying off your personal loan early might seem like a good idea. However, paying off a loan early has a few negative consequences.
In this article, we will discuss if paying off a personal loan hurts your credit score.
How Paying Off a Personal Loan Early Impacts Your Credit
Simply put, paying off a personal loan early can have a short-term negative effect on your credit scores.
It's reasonable to ask yourself, "Isn't it good to get out of debt?" It usually is, too. However, there are a number of things that credit bureaus consider before assigning you a score. Paying off a personal loan can impact your credit score by changing things like your credit mix, payment history, and credit utilisation.
Your different kinds of loans make up your credit mix, which accounts for 10% of your FICO score. Credit cards, student loans, mortgages, car loans, and personal loans are all possible examples. Maintaining a diverse credit profile indicates that you use credit wisely, which can improve your credit scores. But if you pay off your personal loan early, you might take that type of loan out of your mix of loans. As a result, you may have less loan variety, which can harm your credit.
Your payment history shows your past and present credit account payments, including the number of accounts that have been paid on time and the length of time that any missed payments went unpaid. If you use a personal loan responsibly and make your payments on time, you may see an increase in your credit score. However, if you pay off the loan early, you will have fewer opportunities to make on-time and full payments.
By taking out a loan and paying it back immediately, your credit report will show a shorter account length. Your credit history length makes up 15% of your FICO score. It is based on the average age of all of your accounts. The longer you've had credit accounts open, the higher your score will likely be.
Therefore, you can lower your credit score and average credit history length by paying off a personal loan early. Your overall credit profile will determine how much your credit score will change.
Lastly, the percentage of your available credit that you use can have an effect on your credit scores. This is also known as "credit utilisation," which makes up 30% of your FICO score. For example, let's say you have outstanding balances on your credit cards, but the balance on your personal loan is lower because you've been paying regularly. This could result in a credit utilisation ratio that is acceptable.
Your credit score might take a hit, but it would probably be minor and short-lived. You should weigh the advantages and disadvantages of prepaying a personal loan carefully before deciding.
How Many Points Does a Personal Loan Take off Your Credit Score?
Taking out a personal loan will usually result in a slight decrease in your credit score due to the hard inquiry that is made when you apply.
However, this decrease, usually less than five points, is temporary and can be offset by making on-time payments. Regular payments over time can improve your credit score as long as you make all payments on time. Ultimately, the effect of a personal loan on your credit score will depend on how well you manage the loan.
When Does It Make Sense To Pay Off Your Personal Loan Early
Paying off a personal loan early can negatively affect your credit score, but there are a few instances where paying off a personal loan early might make sense. Let's find out what they are:
Your interest rate is high
When you have a lower interest rate, it makes less financial sense to repay the loan ahead of schedule.
If your interest rate is low, you shouldn't be too hasty in paying off your personal loan. If you have a loan with a competitive interest rate of 5%, paying it off early will only increase your annual return by 5%. You might get a better return if you put your money into the stock market.
However, if your personal loan has a high-interest rate, you must repay it as soon as possible. You will save more by paying it off early.
If you only have a mortgage debt
Interest rates on personal loans are typically lower than those on other forms of credit, like credit cards or payday loans.
If you owe money on other debts with higher interest rates, pay those off first. Keep your personal loan payments to the bare minimum. Paying off high-interest debt before a personal loan will save you more money in the long run.
On the other hand, if your only other debt is your mortgage, it's wise to pay off your personal loan first. Mortgages have lower interest rates and are eligible for tax deductions.
To lower your debt-to-income ratio
The sum of all your debts, divided by your income, is referred to as your debt-to-income ratio. It is one of the most important factors lenders consider when making lending decisions. While the ideal DTI ratio for homeowners varies depending on their specific circumstances, the Consumer Financial Protection Bureau (CFPB) suggests keeping it at 36% or lower.
Paying off personal loans early can help borrowers with high debt-to-income ratios, as this ratio can be reduced when the loans are paid off.
Your personal loan does not have a prepayment penalty
There may be a penalty for paying off a personal loan early. The prepayment penalty would nullify any money you would have saved by paying off your loan early.
Compare the expense of the prepayment penalty against the potential savings of paying off the loan early. There's a chance that you'll save money by sticking to your regular payment schedule.
However, if your loan has no prepayment penalty, you can easily pay off your loan early.
You want to free up your budget
Having loan payments can take up a chunk of your budget. Therefore, wanting to pay off your personal loan early is plausible.
Once you've paid off your loans, you'll have more money available for other expenses. You could have more spendable money at your disposal, which could be put toward investing, saving for a down payment, or put to better use.
When Is It Better Not to Pay The Loan Early
While it may seem best to pay off the loan early, there are a few cases in which waiting can be more beneficial.
You might incur an early repayment penalty
It's essential to consider the early repayment penalty. As stated above, many loans have a penalty or fee associated with early repayment, so you must make sure the savings you get from the early repayment outweigh the cost. If the fee is too high, paying off the loan early may not be worth it.
Your other investments are giving you better returns
It may be more beneficial not to pay off the loan early if you are getting a higher rate of return on other investments. Paying off the loan early means you are missing out on potential investment opportunities. If your investments provide a higher rate of return than you'd get from paying off the loan early, then keeping your capital in those investments may be more beneficial.
Your loan is almost paid off
Finishing the loan payments ahead of schedule can help you save on interest if you do not have any prepayment penalties.
However, after making on-time payments for most of the term, suddenly paying it off right before the term ends is not a good idea. Making on-time payments helps you improve your credit and positively impacts your credit score. Therefore, continuing to make on-time payments can be more beneficial than paying them off right before the terms of your loan end.
You don't have any savings
It may be beneficial to wait until more money is saved up before paying off the loan. If you only have a certain amount of money available and need to use it to pay off the loan, it is best to wait until you have saved up enough money to pay off the loan in one lump sum. This can help you avoid the early repayment penalty. Having an emergency fund is crucial in case something unexpected happens.
Overall, it is important to consider all the pros and cons when deciding whether or not to pay off your loan early. If the early repayment penalty is too high or you are getting a higher rate of return on other investments, waiting may be more beneficial. However, if you have enough money saved up, paying off the loan early to save on interest can be helpful.
How to Increase Your Credit Score After Paying off a Loan Early
Paying off a loan can cause a slight dip in your credit score, but you can quickly raise it back up with these few tips:
Fix any mistakes you find on your credit report
Fixing any mistakes on your credit report could be a quick way to raise your score. If you're successful in disputing the items and getting them removed, your credit score could rise.
About one in four Americans have a mistake on their credit report, so it is important to check. Fraudulent or duplicate accounts and incorrectly reported payments are two common mistakes to watch out for.
Lessen your requests for new credit
There are two kinds of inquiries into your credit history: hard and soft inquiries.
A standard soft inquiry could be you monitoring your credit, allowing a potential employer to check your credit, lenders you already do business with checking your credit, or credit card issuers checking your file to see if they would like to give you pre-approved credit deals. Soft credit inquiries do not have an impact on your credit score.
On the other hand, hard inquiries can hurt your credit for a long time, maybe up to two years. Credit card applications, mortgage applications, car loan applications, and other forms of new credit applications are all examples of hard inquiries.
Manage your bills
Five factors determine your credit score; payment history accounts for 35% of it. Therefore, payment history plays a significant role in determining your credit score. That is why paying off your debts and making on-time payments are crucial to raising your credit score. You can easily make sure you pay your dues on time by making a filing system, which can be on paper or digital. You can also put up reminders for your due dates or use automated bill payment systems.
Keep your credit utilisation at 30% or less
The term "credit utilisation" describes how much of your available credit is actually being used. It's the second-most-important factor in determining a person's FICO score, right behind their payment history.
Paying off credit card balances completely every month is the simplest way to keep credit utilisation low. If you find yourself unable to do so, a good rule of thumb is never to let your outstanding balance exceed 30% of your available credit. The next step is to reduce that number to 10% or less, which is the ideal spot for improving your credit.
Do not close out old accounts.
Your credit score considers the length of time you've had credit accounts. Lenders will view you more favorably if your average credit age is longer.
Don't close your old credit accounts just because you aren't using the credit in them. Closing credit card accounts while still carrying a balance on other cards will reduce your available credit and raise your credit utilisation ratio. Still, the credit history for those accounts will remain on your credit report. That might lower your score by a few points.
Paying off a personal loan can negatively affect your credit score, but the effects are minimal and can be taken care of by practising good credit habits. You must ensure you know of any prepayment penalties associated with your personal loan. That way, you can determine if paying off your loan early is worth the penalties or not.
Remember that your credit score depends on five factors: payment history, credit utilisation, account age, credit mix, and new credit accounts. Therefore, focusing on managing all of these factors will help you keep your credit score in good standing.