Will Paying Off a Personal Loan Early Hurt Your Credit Score?

If you’ve taken out a personal loan and you have some extra cash, you might be wondering, does paying off a personal loan early hurt your credit score? We will answer this question in much detail below.

Will Paying Off a Personal Loan Early Hurt Your Credit Score?

Oftentimes paying off a personal loan early can either have no impact on your credit score or can hurt your credit score because it can potentially reduce your credit mix, which refers to the diversity of the active accounts on your credit report. This is especially true if the loan you’re paying off is your only personal loan. Your credit mix accounts for 10% of your credit score, the more diverse the type of active accounts on your credit report, the higher your credit score will be.

That said, the drop caused by paying off a personal loan early is temporary and if there is nothing negative on your credit report, your credit score should rebound within just a few months of paying off your personal loan.

Paying off a personal loan early will not remove it from your credit report. Paid off personal loans where you haven’t missed any payments, remain on your credit report for 10 years from the date you paid off the loan. After the 10 year period, the loan is automatically removed from your credit report.

However, if you’ve paid off a personal loan where you’ve made late payments on the account that were reported on your credit report, such loans will remain on your credit report for 7 years from the date you missed your first payment on the loan. After the 7 year period, the loan will be automatically removed from your credit report.

Why does paying off a personal loan hurt your credit score?

Paying off a personal loan early can lower your credit score because your paid-off account will show up as closed on your credit report, reducing your credit mix. Having a diverse credit mix accounts for 10% of your credit score, so closing the account may lower your credit score, especially if it’s your only personal loan or installment account.

Also, paying off a personal loan may hurt your credit score because open accounts that you’re actively making payments on show lenders how you’re managing your credit right now, whereas paid-off accounts only show lenders how you’ve handled debt repayment in the past.

So, if you want to improve your credit score, you should keep your personal open and avoid paying it off early. Continuing to make payments on your personal loan can be better for your credit score than paying off the loan early.

Keeping your personal loan open for longer can improve a thin credit file. A thin credit file is one that does not contain sufficient credit information. Paying off a personal loan for longer can help you remedy a thin credit file. So, even if you have the funds to pay off your loan early, it could be beneficial to keep the loan open for longer to establish good credit history.

Additionally, keeping a personal loan open for longer improves your credit mix. Your credit mix refers to the diversity of the accounts that are currently open, such as credit cards and installment accounts. Personal loans are a type of installment account that can improve your credit mix and raise your credit score.

Should You Pay Off Your Personal Loan Early?

When deciding whether to pay off your personal loan, there are a couple of things that you should consider, here are some of those things:

1. Interest On Your Personal Loan

If the interest rate on your personal loan is very high, it may make sense for you to pay off the loan early in order to avoid paying interest on the outstanding amount that’s due. However, before you go ahead and pay off your personal loan, you should first check with your lender to see if they charge a pre-payment penalty. A pre-payment penalty is a penalty fee that lenders charge to those who pay off their loans early. Also, if you have a precomputed interest loan, this means that the total interest was calculated and fixed at the beginning of the loan. So, if you were to pay off the loan early, you would already be paying the interest on the loan. If you have a precomputed interest loan, you will not save any money on interest as you would be paying it by paying off the loan. So, consider these things before rushing to pay off your personal loan early.

2. Lowering Your DTI (Debt to Income Ratio)

If you’re applying for a home loan or financing a vehicle, your lender may require you to lower your debt to income ratio, meaning you must pay down some of your debts to be approved for credit. Most lenders require your debt to income ratio to be below 43%, and ideally, your DTI should be 31% or less. Paying off a personal loan can be a way to reduce your debt to income ratio, making it more likely that you’ll be approved for a home loan or other types of credit. So, if you’re going to purchase a home and need financing in the near future, you should consider paying off your personal loan to lower your DTI in order to be approved.

3. Other Types of Debt

If you have a lot of open credit cards and other loans with debt, it may make sense for you to pay off your personal loan in order to tackle paying off your other debts. This is especially true if you have other personal loans, credit cards, student loans, and auto loans. Even if paying off your personal loan causes a small drop in your credit score, don’t worry too much about it as the drop is likely temporary. In fact, your credit score will likely improve within a short period of time.

When Should You Avoid Paying Off a Personal Loan Early?

Here are some situations in which you should avoid paying off a personal loan early:

1. Interest On Your Personal Loan is Very Low

If you’ve taken out a personal loan and the interest rate on your personal loan is very low, paying it off may not be worth parting with your cash. For example, if you have a personal loan at a 5.0% interest rate, and you have credit card debt at 15%, it will make more sense for you to pay off your credit card debt before tackling your personal loan debt because you will be paying significantly more on the debt you’ve accumulated on your credit cards.

2. Keep Your Cash On Hand

Experts have come to a consensus that every person should have three to six months’ worth of expenses saved up for an emergency. So, if you have extra cash burning a hole in your pocket, you should save it up and only make the monthly payment on your personal loan until you’ve saved up at least three to six months’ worth of expenses. Once you’ve established an emergency fund, it makes sense to contribute more money to pay off your personal loan debt.

3. Your Personal Loan is Substantially Paid Off

If your personal loan is substantially paid off an you only have a few payments remaining, it doesn’t make sense to pay it off early because you will not save much on interest by paying it off early. In this case, it makes sense to continue making payments on the loan in order to improve your credit via timely monthly payments. It will only make sense to pay off your loan early if you need to lower your DTI quickly in order to qualify for a large purchase such as borrowing money to buy a home or finance a vehicle.

Conclusion: Should you pay off your personal loan early?

If you have extra cash on hand and you don’t mind your credit score temporarily drop some points, you should go ahead and pay off your personal loan. However, if you’re planning on making a large purchase, such as a home, in the near future and your debt to income ratio is within a good range, you should hold off on paying off your personal loan to maintain the best credit score possible while qualify for a mortgage.

Also, it may make sense to pay off a personal loan if you don’t have credit card debt that you’re paying a high interest rate on. If you do have credit card debt, you’re better off paying down your cards because the interest rate on credit cards is typically much higher than that of personal loans.

So, ultimately it’s up to you, but now you have the knowledge necessary to weigh the pros and cons of paying off your personal loan early.

Frequently Asked Questions (FAQs)

1. Why does my credit score drop when I pay off a loan?

When you pay off a loan, including a personal loan, you’re essentially closing down an installment account. Closing an installment account can lower your credit score because it may reduce your credit mix (diversity of accounts on your credit report). Your credit mix accounts for 10% of your credit score, and may be reduced when you pay off a personal loan.

2. Will my credit score increase if I pay off a personal loan?

It is unlikely that paying off a personal loan will increase your credit score. In fact, your credit score will either stay the same or drop a few points when you pay off a personal loan. Your credit score may temporarily drop because you’re closing an installment account which can reduce the diversity of your accounts.

3. Should I pay off my personal loan early?

If your personal loan is your only loan, you should hold off on paying it early as it can reduce your credit mix and result in a lower credit score. Also, you should pay off other higher interest rate debt before paying off a personal loan. It really all depends on your situation. This blog post discusses the pros and cons of paying off a personal loan early, weigh them and make your decision.

4. Can paying off a personal loan hurt my credit?

Yes, paying off a personal loan can result in a slightly lower credit score. That said, a drop in your credit score is likely to be temporary and so long as nothing negative on your credit report appears, it should rebound within just a few short months.

5. What debt should I pay off first?

You should pay off your highest interest rate debt first.