Will Paying Off a Loan Improve Credit?

How Does Paying Off a Loan Affect Your Credit?

Paying off a loan might not immediately improve your credit score; in fact, your score could drop or stay the same. A score drop could happen if the loan you paid off was the only loan on your credit report. That limits your credit mix, which accounts for 10% of your FICO^® Score^☉ . It's also possible your score could fall if your other credit accounts have higher balances than the paid-off loan.

Even so, in general, getting rid of a loan is a win: You'll have more flexibility with your finances, and you'll no longer accrue interest charges on the loan's balance. So, if paying off a loan makes sense for you, avoiding a brief credit score drop shouldn't be a reason to keep the account open. Also, reducing debt will lower your debt-to-income ratio, which lenders will be glad to see if you seek out a new line of credit once the loan is paid off.

What Happens to Your Credit If You Pay Off a Loan Early?

Paying off installment debt like personal loans and car loans won't necessarily help your credit scores. If you get rid of these loans early, the impact on credit will be slightly different than if you make a large payment to reduce your credit card balance, for instance. That's because installment loans will appear as "closed" on your credit report when they're paid off, and open accounts with positive payment history have a stronger positive impact on your credit score than closed accounts.

You may consider making payments as agreed throughout the loan term (rather than contributing an early lump-sum payment) if your loan's interest rates are low or 0%, if you don't have emergency savings, or if there are only a few months left on the term and you can make use of the resulting positive effect on your credit.

Should You Pay Off Debt Early or Continue Making Payments?

Since your credit score may not improve if you pay off a loan early, it's natural to wonder whether you should prioritize debt payoff at all.

First, make sure you have enough emergency savings to carry you through a potential period of unemployment or other unforeseen event. Ideally, you'll have three to six months' worth of basic expenses saved at all times—which means avoiding dipping into savings to pay off debt.

If you have a robust emergency fund, however, and you're saving for other goals like retirement and perhaps a down payment on a home, then you may decide to use extra funds to pay off a loan. There are several reasons why getting debt-free is a goal worth working toward, whether or not you'll experience a credit score boost afterward.

• Lower debt-to-income ratio: When you pay off debt, your debt-to-income ratio (DTI) decreases, since you now have smaller monthly debt payments compared with your income. That's one of the primary factors financial institutions use to make mortgage lending decisions, for instance, so if you're in the market for new credit in the future, lowering your DTI could be valuable.
• Interest savings: The moment you pay off a personal loan that carried an interest rate of 9%, for instance, you'll get access to the money you were previously putting toward your monthly bill. You can allocate the money you were previously paying toward other debt or toward savings.
• Peace of mind: Debt can feel like a cloud hanging over you, especially when it's keeping you from pursuing goals you're passionate about. Eliminating a monthly debt payment from your budget gives you innumerable new possibilities for making use of that money. Celebrate when you pay off a loan; the flexibility and freedom you'll now feel can be priceless.

One more thing to consider: A personal loan might not be the best debt to prioritize if your goal is becoming debt-free and saving money. Generally, loans carry a lower interest rate compared with other types of debt, such as credit cards. Before you decide to pay off a loan, take a look at your other debts. It might save you more money overall if you focus on the debt with the highest interest rate.

Other Ways to Improve Your Credit

You have plenty of other options if improving credit is your biggest goal. Continue to make timely payments on all of your accounts and keep credit card balances to a minimum, ideally charging no more than 30% of your credit limit on each credit card at any point. This will ensure your credit utilization rate doesn't negatively impact your credit score, but to see credit improvement, the lower your utilization is, the better.

It's also important to maintain a healthy average account age, which means you should avoid closing your oldest credit card accounts unless they carry a fee that makes it a financial burden to keep it open. That doesn't mean you have to use them very frequently. One small purchase per month that you pay off immediately will signal to lenders and the credit bureaus that you have a handle on responsible credit usage over time.

Paying Off a Loan vs. Waiting It Out

It's a personal choice whether to keep a loan account open for its full term or to pay it off early. But there are a few circumstances when the decision is relatively clear: If you're trying to use extra cash to build up an emergency fund, or your loan's rate is very low, it may be best to pay the loan over time as agreed and benefit from the positive credit impact.

On the other hand, perhaps you need a low debt-to-income ratio to qualify for a new loan, or you have the means to pay off the loan and you don't plan to take out any new credit in the near future. In these cases, freeing yourself from the loan, and accepting a brief potential credit hit, could be a good bet.