Is it bad to pay off a car loan early? Does paying a car loan off early hurt your credit? Maybe you are pondering these questions if you received a financial windfall or have a hefty amount of cash in reserves and would like to eliminate your car payment.
The short answer is that it depends. Your credit score could drop by a few points shortly after paying the loan in full, but the impact is usually only temporary.
4 ways paying off your auto loan early affects your credit
Several components are used to calculate your credit score. Here’s how each is affected when you pay off your auto loan early:
1. Payment history
Each time you make a timely payment on your car loan positive payment history is added to your credit report. Over time, these payments improve your credit score. Paying off a car loan closes the account, and it remains on your credit report for up to 10 years. However, positive open accounts have a more significant effect on your credit score than closed accounts as they demonstrate how you’re currently managing credit, rather than how you did in the past.
2. Credit utilization
Paying your loan down over time gradually lowers your credit utilization and could give your credit score a chance to improve. But you may not get the same outcome if you pay the loan off early.
3. Length of credit history
The lengthier your credit history, the better shot you have at achieving a good or excellent credit score. If you’re working towards building or repairing your credit, it’s best to keep the auto loan open to build up a positive credit history.
4. Credit mix
Lenders like to see a healthy mix of revolving accounts, like credit cards, and installment accounts, like auto loans. If you pay off a car loan early and it’s your only installment account, your credit score could take a hit. And if you have very few credit accounts, the hit to your score could be even greater.
When to pay your car loan off early
Paying off your auto loan early could be a good idea if you can afford to do so without hindering the progress you’re making towards other more important financial goals. These goals could include eliminating high-interest credit card debt or building up your emergency fund.
Or maybe you’re planning to buy a new home soon, and the lender likely won’t approve you for a loan until you lower your debt-to-income ratio. In that case, paying off your car loan early could also be sensible.
Other reasons to pay off your car loan early include freeing up funds to boost your nest egg, building wealth through investments or starting a business. But if the lender assesses prepayment penalties, you will need to weigh the costs to determine if it’s a smart financial move.
The bottom line
Ultimately, paying off your car loan early can get you one step closer to debt freedom and financial security. However, it can temporarily drop your credit score and set you back financially if the lender charges early termination fees. So, it could be worthwhile to keep making loan payments over time.