Does Paying off a Loan Early Hurt Credit? Your 2024 Guide

Paying off your loan early can wipe out the excessive burden of recurring debt payments. Once your loan amount is paid off, you can move on to seeking new financial achievements. However, paying off a loan early might cost you some points and will most likely not look good on your credit report. This leads us to the big question, does paying off a loan early hurt credit?

The answer to this question is not the same for everyone just like most of us have different financial circumstances. To begin, you have to understand that Fair Isaac Corporation (FICO), a widely used credit scoring system, focuses on open debt accounts rather than closed ones. This is the first indication that it can impact your credit score. Also, clearing your loan early can change your credit history length and credit mix.

In this blog, you’ll understand how paying off a loan early hurts your credit, what are the possible penalties, and more. We will also share tips related to how you can improve your credit score.

Does Paying Off a Loan Early Hurt Credit? The Real Truth

Paying off your loan might give you a feeling of relief and accomplishment. However, it can negatively impact your credit score. It might happen because once the loan is paid, your debt account will be closed. An inactive loan account does no good to your credit score as FICO focuses only on active ones.  

FICO doesn’t share the exact model it uses to calculate your credit score but tells how it is weighted. One indicator is the ratio of loan balance to loan amounts. If this ratio is low, then FICO considers you a good borrower, as it shows that you’re capable of making on-time repayments.

This means if you have no active loans, your credit score can drop. However, this drop in credit score is specific to your current financial situation.

Note: Your credit history length and credit mix can be hurt if you pay off a loan early. Drastic changes in these two can lower your credit score.

Installment Loans and Revolving Credit

Installment loans and revolving credit accounts are vital aspects when you seek an answer: does paying off a loan early hurt credit? 

Study and mortgage loans are fine examples of installment loans. These loans help you receive a lump sum amount of money for predefined purposes. You have to make recurring payments to pay off these loans, which include the full borrowed amount, interest, and other fees.

These loan accounts are part of your credit mix along with revolving credit accounts. Your revolving credit accounts deal with always available credit lines that you can use monthly. You also have to clear these revolving loans with monthly payments. The payment amount includes the credit balance used, fees, and interest.

A Quick Tip: You can improve the quality of your credit mix with diverse active loan accounts. Also, ensure you make on-time payments to avoid any interest penalties.

When you pay off installment loans early, it hurts your credit score and credit mix. Paid off loans become closed accounts and it indicates that you’re not handling diverse credit accounts. It can disrupt your credit mix which makes up 10% of your FICO score. In the end, these factors will hurt your credit, even though you paid the entire loan amount with interest and fees.

However, you don’t have to brood about this situation too much as it can be changed. You can uplift this credit drop by responsibly managing your active loan or credit accounts.

Is It Good to Pay Off a Loan Early?

Paying off a loan early certainly has its advantages. Let’s see if it is a good idea or not.

Early Pay Off	Scheduled Pay off
Lower your debt-to-income ratio	Avoid prepayment penalties
Reduces your debt balance	Eliminate possibilities of credit shrink
Less interest amount	Strengthen your credit history length

How Does Paying Off a Loan Early Hurt Credit? Hidden Risks

Paying off a loan early has a few hidden risks. You might have to pay penalty charges, which can lower your credit mix. It also impacts your credit history length, leading to a lower credit score. So before you decide to pay your loan in one go, weigh the possible hidden risks with advantages. Let’s see if paying off a loan early hurts credit.

▪ Prepayment Penalty of Paying Off Loan Early

Many contracts come with a prepayment penalty of paying off a loan early, and they vary depending on your loan contract terms and the state you live in. Your lender might charge you for paying the loan off at once if the terms for prepayment penalty are included in your contract. If you find a prepayment penalty clause in your contract, then figure out the penalty amount. Check if it is worth paying the loan in advance or should you keep making recurring payments to avoid paying extra. 

▪ Disrupted Credit Mix

FICO’s credit score model is quite discreet. However, it clearly says that credit mix makes up 10% of your credit score. This means if you pay off your loan early, your credit mix can shrink. 

You can avoid this drop in the credit mix by managing multiple active credit accounts such as credit cards, auto loans, mortgages, and more. It will show the lenders that you are capable of paying multiple recurring payments, leading to a better credit score.

▪ Weak Credit History Length

A longer credit history certainly has a positive impact on your credit. According to FICO, credit history length makes up 15% of your credit score. Paying off a loan early can lower the average length of your accounts. That’s why you should keep your older loan or credit accounts open to improve the length of your credit history.

Is It Good to Pay Off a Loan Early? Your Benefits

The benefits of paying off a loan early are the key attractions. Let’s see what benefits you can get from an early payoff. 

1. Lower Your Debt-to-Income Ratio

Your debt-to-income ratio makes a big difference when you apply for a new loan. Lenders check your current debt amount and compare it with your income to measure the debt-to-income ratio. If you pay off a loan early, then your DTI ratio can be improved, and the chances of new loan approvals increase. 

2. Reduce Your Debt

The debt amount owed on your various credit accounts, such as credit and retail cards, impacts your credit. It makes up 30% of your FICO score, and this is one of the largest contributing factors to your credit score. If you pay off your loan early, then it can help you reduce the amount of your owed debt. It can help you improve your credit performance.

3. You Will Pay Less Interest

You have to pay the principal amount and interest to your lender in recurring payments. Paying off a loan early might eliminate interest payments, and you can save extra money. 

However, ask yourself this question when planning to take action in this matter: Is the interest included in paying off early on your loans? If your loan contract includes prepayment penalties, then you might have to pay interest. So be careful and make calculated decisions when paying off a loan early.

When Should You Pay Off Your Loan Early?

A few factors can help you understand when to pay a loan early. Here’s what to consider:

Consider Paying Early If	Avoid Paying Early If
You’re paying a high interest rate	Your credit history length is limited
Your loan contract doesn’t have any prepayment penalties	Managing recurring payments has a positive impact on your credit
You’re planning to lower your debt-to-income ratio	The interest rate is low
You don’t want to pay interest	You want to save money for emergency funds and pay off other high-interest loans

Ways to Improve Your Credit Score

You might want to improve your limited credit history or bad credit or avoid the prepayment penalty of paying off a loan early. These situations are unique just like your credit score and there is no one solution for all methods to improve it. These tips can help you kick-start your journey to achieve a good credit score.

▪ Get Help From Trusted Friends and Family

You can become an authorized user of your trusted family and friends' credit card and take advantage of their good credit scores. However, you have to ensure they are managing their credit accounts properly and making on-time payments. Also, the account should be open for a while with a low credit utilization ratio.

▪ Pay On-Time

On-time payment history is a deciding factor in credit score. If you maintain a good payment history, your score can be improved. Also, on-time payment helps you avoid possible interest penalties that can damage your finances. 

▪ Work on Your Credit Mix

Creating a balanced credit mix doesn’t mean you have to open unnecessary credit accounts. Focus on your credit needs and open or close accounts with calculated information. 

▪ Keep an Eye on Credit Reports

Credit reports can hurt your credit score if there are any errors in it. That’s why you should monitor your reports regularly. Equifax, Experian, and TransUnion – three major credit reporting bureaus – help you get a free credit report each year according to the law. You can also access weekly reports from these platforms to keep a sharp eye on your credit.

▪ DIY Credit Repair App

Maintaining good credit and going through credit reports and other factors can be tricky. To tackle this situation, you can try using DIY credit repair apps like CoolCredit. It can help you repair and boost your credit with the help of AI and expert assistance. The app can help you generate dispute letters, monitor your credit, and track progress. You can also find high-quality educational material that can help you understand how to boost, improve, and recover your credit.   

Conclusion

Managing, boosting, or recovering credit is a delicate process, and paying off a loan early might hurt it. You have to closely monitor your credit situation to figure out whether to pay it according to the schedule or take a leap to pay it early. You can leverage the power of DIY AI credit repair apps like CoolCredit to make your job easy. 

This way, you can access the power of AI and expert assistance simultaneously. You can also get your hands on elaborate educational materials that can help you find the right answers to questions like does paying off a loan early hurt credit, whether you should pay off a loan early, and more. Simplify your credit score improvement journey right away!