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If you are currently paying down a loan, chances are it’s an installment loan – which refers to any type of loan that is repaid via regular installments, or monthly payments, with interest included.
An installment loan can have terms between just a few months or even as much as 30 years, depending on the type of loan. Either way, they are defined by their repayment schedule. Borrowers must repay the same amount each month (with a few student loan exceptions that gradually get larger as graduates’ careers get built over time) – unlike credit cards, which are known for fluctuating monthly minimum payments. Credit cards are referred to as “revolving credit.”
Mortgages, student loans, car loans, and even personal loans are all examples of installment loans, and a ton of us are begrudgingly making monthly payments just to chip away at one or more of them.
It is common knowledge these days that making regular, on-time payments toward installment loans is good for a borrower’s credit score, but what if you come up with enough cash to pay off the entire thing? What happens to your credit score when you make a huge payment and finish off the loan?
What Happens to Your Credit Score?
Intuitively, a lot of people assume that paying off a piece of debt completely would be a boost to our credit scores. It makes sense, right? It seems likely that closing an outstanding installment loan would demonstrate to credit reporting agencies – like Equifax – that you are a responsible borrower.
The reality, however, goes against that logic. In fact, paying off an installment loan early will have little positive influence on your credit score. Just 15 percent of your credit score is affected by how many loans you have and which type of loan each one is.
Meanwhile, about 35 percent of your credit score represents your payment history – a solid record of on-time monthly payments holds much more weight than simply knocking one of the loans off your list. If you are successfully paying your monthly installments, you are strengthening a healthy credit score.
Credit agencies like to see things like:
- A variety of different types of loans/credit
- A history of on-time payments
- Accounts that you have been paying regularly for a long time
To put it simply, having an open account attached to your credit (if you are paying your installments on time) has a higher positive impact than having a closed account from a paid-off installment loan.
A popular misconception is that a closed account disappears from your credit report, but credit reporting agencies (especially FICO scores) take both open and closed accounts into consideration.
When you pay off a loan, effectively closing the account, it will remain in your credit report for:
- Seven years if you made late payments
- Up to ten years if the loan was paid off in good standing
If I Pay Off My Installment Loan, Will It Hurt My Credit Score?
While paying off a credit card is certainly good for your credit score, installment loans don’t work in the same way. But don’t worry, it is unlikely that paying off an installment loan in full will decrease your credit score. It may have a slight positive impact on your credit, especially if the loan was paid on-time each month, but that positive impact might be very limited.
In fact, there are very few negative effects of paying off a loan early: it won’t make your credit score dip, you will have one less monthly debt payment to worry about, and you can free up your credit to take on another loan if you are thinking about financing an upcoming purchase. You will also save a lot of money on interest. Just how much? Check out our Debt Repayment Calculator to find out!
The only negatives are that you will no longer have the lump sum that you used to pay off the installment loan, and your credit score will no longer continue to be nourished by the regular payments being made to an open account.
Sometimes paying off an installment loan comes with more mental benefits than fiscal ones, and each one of us has our own individual situations – there is no one-size-fits-all recommendation.
If you are pondering paying off an installment loan completely, think about the benefits and possible downsides – and definitely don’t pay it off just to boost your credit score. Pay off a credit card instead.
Author: Jeff Gitlen