At Addition Financial, we often discuss issues related to credit and credit scores with our members. One question we hear a lot is this:
Will paying off my car loan early impact my credit score?
It’s an important question to ask before you repay your loan early–and we’re here to help. Here’s what you need to know about early repayment of auto loans.
Is paying off a car loan early an option? The answer is yes but it may not be the right thing to do depending on the terms of your loan and your specific financial circumstances.
For some people, paying off a car loan early may be desirable because it reduces their overall debt and gives them full ownership of their vehicle. That said, it’s important to be aware that many car lenders charge a prepayment penalty. They do so because they lose money in the long term if you pay early because they won’t be charging you interest for the months between your payoff and the original end of the loan term.
Prepayment penalties are calculated as a percentage of the remaining loan balance and may vary from state to state. Some states have placed a cap on the amount lenders can charge. That said, the average prepayment penalty for auto loans is 2% of the remaining balance. If you had $20,000 left on your loan and your loan agreement had a prepayment penalty, that would transfer to $400 in addition to your loan balance.
The process of paying off a car loan early is simple. Here are the steps you would follow:
Keep in mind that it may take as long as six weeks to get the title to your car, but you should follow up if you do not receive it in a timely manner. You will need the title in the event you decide to sell your vehicle.
It’s always important to consider how your financial decisions may impact your credit score because your score can play a role in your ability to buy a home, apply for credit cards, and in some cases, it can even impact your employment.
There are several ways in which paying your car loan early will have an impact on your credit score.
Your credit utilization is expressed as a percentage and reflects the amount of the total revolving credit available to you that is being used at any point in time. Revolving credit includes any credit that may be paid down and then used again, including credit cards and lines of credit. It does not include installment loans such as auto loans.
What that means is that your credit utilization is unlikely to be affected by early repayment of your car loan unless your repayment makes it more difficult for you to make other payments on time. To avoid an unnecessary increase in your credit utilization, make sure that you’re not depleting your savings account or emergency fund to pay off your car loan.
Part of your FICO score is determined by your credit mix. In general, it’s most desirable to have a combination of revolving credit and installment credit, which would include things like your car loan or mortgage.
If you don’t own a home and your car loan is your only installment credit, then you probably will see a negative impact on your credit score if you repay the loan early. If your score is excellent, then it may not matter as much as it would if your score were lower.
Your payment history is responsible for 35% of your FICO score and is thus the thing that is most likely to impact your credit. Open accounts have a more significant impact on your credit score than closed accounts, so there is a chance that paying off your loan early will cause a dip in your score.
Making on-time payments is one of the best ways to improve your credit score. So, if you’re someone who’s been working to build (or rebuild) your credit, paying off your car loan early may not be the best choice, since doing so will mean that you’re no longer making on-time car loan payments.
Lenders like to see a long credit history when they pull a credit report because it allows them to evaluate a potential borrower’s ability to repay a loan or credit card balance. Car loans stay on your credit report for 10 years, but if you repay early, that loan will disappear earlier, too.
If you have other installment loans such as a mortgage or a student loan, then it may still be worthwhile to pay your loan early if doing so presents financial advantages. But, you may want to keep the length of your credit history in mind as you weigh your options.
Any time you apply for a new loan or credit card, the creditor will make a hard credit inquiry that will cause a small dip in your credit score, usually no more than five points. If you intend to repay your auto loan with a personal loan, a home equity loan or a home equity line of credit, then you will see a small drop in your score as a result.
Because the impact is small, it may still be worthwhile to apply for a new loan to pay off your auto loan at a lower interest rate. Keep in mind that there is a 14-day grace period for loan shopping, so you can apply with multiple lenders and only see one hard credit inquiry on your credit report.
Even when considering the potential impact on your credit score, there are still times when it may make sense to pay off your car loan early. Here are some examples:
We should note that if you have debt with interest rates that are higher than your car loan, we would recommend paying down those balances first to save money.
The bottom line is that paying your car loan early may have an impact on your credit score. As a rule, we would recommend looking at your broad financial picture to make a decision, including reviewing your other debts and interest rates as well as how repaying your loan will impact your ability to meet your other financial obligations.
Are you looking for an affordable way to pay off your car loan early? At Addition Financial, we have multiple options available to consolidate car loans and pay your balance. Click here to learn about our personal loans and start the application process today.