When you want to build credit, paying off debt is always a smart move that helps. This is especially true when you have a large amount of debt that might impact your debt to income (DTI) ratio, which can affect your eligibility for getting a personal installment loan.
Why My Credit Score Might Go Down When Paying Off Debt?
When you pay off debt early that isn’t related to credit cards, it can make your profile less credit-worthy according to some of the scoring models used.
This is because of the difference between revolving credit (e.g. credit cards) versus installment loans, or lines of credit, such as a personal loan or mortgage. To pay off an installment loan early doesn’t improve your credit score. In fact, it may take a dip, but it’s usually small and temporary. Also, when you pay off early you would be missing out on the opportunity to make positive payments that would be reported. When it comes to your credit score, every bit helps since it takes time to build.
Additionally, if you were to see your credit score drop around the time debt is paid off, your score can vary for many reasons. This might include if you had recently applied for another loan or credit card, or you’ve racked up high credit card debt around the same time.
When you pay off a debt, that account is removed from your credit report, which can also affect the average age of all accounts and cause a decrease, and possibly affect your credit mix, which accounts for 10% of your score. Since a large part of your credit score (35%) is based on history and making payments on time, if you’ve been paying off debt like a personal loan for several years and chose to pay the rest early, that source of positive payments goes away along with your aged account on your credit report.
Does Paying Off a Loan Early Hurt My Credit Score?
While it can provide some relief to take care of your debt and pay it off early, sometimes you want to think about this before moving ahead. A credit account that has been around with strong on-time payments can be better to keep on your credit report. It shows potential lenders or creditors your financially responsible and creditworthiness.
You should also check the terms of your loan before paying it off to ensure there are no concerns like loan pre-payment penalties that might cost you. These are how some lenders would regain revenue from some of the interest of the loan if the account were paid early.
Overall, there aren’t really any benefits to paying a loan off early other than the possibility to save on interest if you were to keep making the payments. But as previously mentioned, while it can improve your DTI, the account would be removed from your credit report when paid off which has ways of affecting your credit score.