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You have a little extra money and you'd love to pay off your personal loan early. Doing so will save you on interest and put a few extra dollars to spend in your pocket each month. So, should you repay your personal loan ahead of schedule?
Paying off debt is generally good for your finances—and good for your credit. But before you pay off that personal loan, consider the consequences. Personal loans sometimes come with prepayment penalties. And while paying off a personal loan ahead of schedule certainly won't ruin your credit, it can set your credit back a tick if you're working on building a credit history. Here's what you need to know.
How Paying Off a Personal Loan Early Can Affect Your Credit
If paying off your personal loan on time is good for your credit, shouldn't paying it off early be like extra credit? Unfortunately, it's not.
Paying off your personal loan is also not like paying off your credit card—at least as far as your credit is concerned. If you monitor your credit regularly and have made a large payment to a credit card account, you may have seen your credit score take a nice little hop after the payment posted. That's because you reduced your credit utilization, or the amount of available credit you're using, on your established card account. Typically the lower your credit utilization, the better your credit scores.
Paying off a personal loan is different. When you pay off an installment loan, your credit report shows the account as closed. When calculating your credit score, FICO weighs open accounts more heavily than closed accounts. Open accounts are considered a measure of how you're managing debt in the present as well as the past. Your successful payments on paid off loans are still part of your credit history, but they won't have the same impact on your score.
When you added a personal loan to your credit history, you increased your number of active accounts and improved your credit mix with an installment loan. When you close the account, you will reverse the process: You will now have fewer open accounts and less account diversity. If you paid your loan off early, your history will reflect a shorter account relationship.
The same isn't true when you pay down your credit card. There, even if you pay your balance in full, the account remains open and your credit line stays intact.
5 Questions to Ask Before You Pay Off Your Loan
Is it ever a good idea to pay off a personal loan early? It can be. Only you can weigh the value of saving on interest, reducing your monthly debt load and even taking a temporary, minor hit to your credit score in the interest of better financial health in the long term.
If you're considering an early payoff, ask yourself these five questions to better understand your situation and motives:
1. Do you need your very best credit score now?
Damage to your credit score from paying off a personal loan early likely won't be catastrophic or long-lasting. But sometimes, such as when you're applying for a mortgage, you're counting on every point of your credit score to help you get a great rate. In this situation, you might want to hold off on repaying your personal loan in full until after your mortgage is approved.
2. Are you trying to reduce your debt-to-income ratio?
Conversely, you might consider repaying now if your debt-to-income ratio (DTI) is critical to qualifying for a loan. Although your DTI does not affect your credit score, lenders—especially mortgage lenders—consider it a key factor when evaluating your loan application. The lower your DTI, the better your chances for approval.
3. Would your money be better spent paying down credit card debt?
Credit card debt typically carries higher interest rates than personal loans. And paying down credit card debt will almost certainly raise—not lower—your credit score. If you're choosing between paying off your loan or paying down your cards, look closely before you act.
4. Will paying off your loan put you at risk?
Using your savings to pay off a loan may save you money on loan interest. But it could also diminish your ability to cope with a financial emergency if one arises. This is less of a concern if your savings are ample, with more than three to six months of expenses in an emergency fund. If your savings are slim, you might want to make sure you aren't putting your finances—and your ability to maintain your clean credit history—at risk by paying your loan off in a lump sum.
5. Does repaying your loan have clear benefits?
Maybe you've done the math and paying your loan off early will save you thousands of dollars. Or perhaps you're refinancing your home and hope to consolidate your personal loan and mortgage payments. Whatever your reasons, be clear on the benefits of early payoff. That's the only way to assess whether or not paying your loan off is worthwhile.
Does Getting a Personal Loan Help Your Credit?
Getting a personal loan and making all your payments on time can boost your credit in a number of ways. A personal loan appears on your credit report as an installment loan—a type of loan that has a specific loan amount and a set repayment schedule. Installment loans are different from the revolving debt you may carry on credit cards. Adding an installment loan to your "credit mix" can improve your credit score because it shows that you can manage different types of debt.
Making monthly loan payments on time adds to your successful payment history—and that's significant. Your payment history accounts for 35% of your FICO credit score and is, in fact, the biggest factor in determining your score.
Be aware that a new personal loan can put a momentary drag on your credit score. Lenders typically run what's called a hard inquiry on your credit when you apply for a loan. These can lower your score by a few points, though the effects are temporary. A new loan also reduces your average age of accounts. This problem starts to resolve itself as you pay the loan off over time, building your history as you go. Initially, however, new accounts make your credit look less "mature."
The Bottom Line
Paying off a personal loan early comes down to your personal situation and how the move will affect your finances and your overall well-being. If you're concerned about how it will impact your credit, consider finding out where your credit score and history stand by downloading your credit score and report from Experian for free. You can also use Experian's free credit monitoring service to see how your score changes as you add accounts, pay off debt and get ready to apply for credit.