How will the prepayment of a personal loan affect my credit?
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Dear credible money coach,
I took out a personal bank loan of $ 20,000 for a year. If I pay it off at the start of the third or fourth month, does that positively or negatively affect my credit rating? -Marc D.
Hi Marc and thank you for your question. First of all, I commend you for managing your finances so well that you are able to prepay a large loan amount.
Anytime you pay off a loan before the end of the term, you can save on the interest charges that you would have paid if you had waited until the full term to pay off the loan. And who doesn’t want to save as much as possible?
But like almost any financial decision you can make, prepaying a personal loan has its pros and cons. To understand how prepaying a loan can affect your credit rating, let’s start by looking at how credit scores work.
Factors that make up credit scores
Credit rating agencies use proprietary models to analyze data from consumer credit reports and generate credit scores. While your credit score may vary depending on the agency that generates it, credit score models generally take into account the same basic factors (in order of importance):
- Your payment history
- Total amounts you owe
- How long have you been using credit (the length of your credit history)
- The combination of types of credit you have
- How many new credit requests or accounts you have
Lenders and credit bureaus view these factors as indicators of how well you have handled credit in the past and how likely you are to handle new credit accounts. A long history of on-time credit payments, a lower total debt amount, and the right mix of credit types can all contribute to a higher credit score.
How repaying a loan can affect credit scores
It is possible (but not certain) that your credit score will drop a bit immediately after paying off a loan. This is because paying down debt affects some of the credit rating factors we just discussed.
When you pay off a loan, whether you do it on time or sooner, as you envision, you are reducing the mix of credit types you use. Credit scoring models usually favor a mix, like credit cards, installment loans, mortgages, etc. A mixture can indicate that you are good at handling different types of credit, rather than just one type.
Paying off the loan also reduces the total amount of your available credit, which in turn affects your credit utilization rate – the comparison of the amount of credit you use against the total amount of credit you have.
If your goal behind prepaying the loan is to give yourself some leeway to take on bigger and bigger debt, like a mortgage, you might not want your credit rating to go down just yet. It might make more sense to devote your money to paying off any credit card or student loan debt you may have.
Why it can always be a good idea to prepay your loan
Now you might be thinking, âDisappointed! I guess I’ll keep my loan.â But despite the potential short-term effect on your credit score, there are very good reasons to pay off your loan sooner.
I already mentioned one: interest savings. Paying off your loan only three months after the start of your repayment period means you save nine months of interest. On a loan of $ 20,000, this amount could be significant, depending on your interest rate.
Then there is the benefit of eliminating a monthly payment that is probably north of $ 1,000. Imagine that you keep this amount of money in your pocket for the rest of the year. What could you do with it? Pay off other higher interest debt? Create an emergency fund? Increase your retirement savings?
Finally, there is the psychological boost provided by debt repayment. It’s a satisfying feeling. If avoiding a temporary impact on your credit score is not a priority right now and you don’t need the money for anything else, go ahead and pay off your loan sooner.
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About the Author: Laura Adams is an expert in personal finance and small business, award-winning author and host of Silver girl, a top rated weekly audio podcast and blog. She is frequently cited in the national media and millions of readers and listeners benefit from her practical financial advice. Laura’s mission is to empower consumers to live richer lives through her work as a speaker, spokesperson and advocate. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Follow her on LauraDAdams.com, Instagram, Facebook, Twitter, and LinkedIn.