“I just want to be done with this debt.” If you’ve ever had a large loan or credit card balance, it’s possible that this thought has crossed your mind. Making monthly payments can be a pain, and the thought of what could happen if you miss a payment can be frightening — which is why some borrowers pay off longer-term installment loans as quickly as possible.
But there’s something important you should know about paying off a long-term loan early versus, say, paying off a credit card balance in full: When it comes to your credit score, there are a few important differences.
You may think paying off an installment loan early will improve your score. Doing so shouldn’t hurt it, but many experts advise that early repayment of a long-term installment loan likely won’t help your score either, especially if you’re only a few payments into the loan.
According to Equifax, one of the three major credit reporting bureaus, "a record of steady payments throughout the life of the loan may be more beneficial to your score than paying it off early." Why? Because about a third of your credit score is based on making consistent, on-time payments.
In addition, Equifax goes on to say that “an open account paid regularly is more beneficial to your credit score than a closed account, which is what your installment loan becomes once it’s paid off." That’s because a large part of your score is based on the diversity of your credit lines. If you pay off a loan, it’s considered “closed” on your report — and your diversity decreases.
Experian, another of the three major credit bureaus, agrees. In a blog post titled "Paying off a debt early won't help credit scores," it states:
"Open and active accounts are scored more highly than closed accounts because they demonstrate that you are managing credit well now and not just in the past .... if you’re making your monthly payments on your installment loans on time and in full, then each month you’re fortifying a healthy credit score."
This isn't to say you shouldn't pay off an installment loan today if you can. First, paying off a loan early should never hurt your score; the credit bureaus do not want to penalize consumers for ridding themselves of debt. Second, because interest accrues on a daily basis, you could save a lot of money by paying off an installment loan early (but check with your lender to ensure there are no pre-payment or early repayment penalties).
For example, assume you had a $1,000, 12-month loan with a 30 percent annual interest rate (APR). If you make regular payments for three months and then pay off the balance in full during the fourth month, you could save around $80 in interest over the lifetime of the loan.
So while there are certainly good reasons to pay off a long-term installment loan early, just keep in mind boosting your credit score may not be one of them.
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