Your credit score is an important figure lenders look to determine if you’re a responsible borrower. It helps determine your approval chances for loans and credit cards, and can help you qualify for lower interest rates. It may also be used to decide your eligibility to rent an apartment or home.
Making regular on-time payments on a loan can help build your credit quickly, especially since your payment history is the larger factor credit agencies look at when setting your credit score. But what happens to your credit after you pay off a loan?
Does Paying Off a Loan Build Credit?
Paying down a loan over time can help positively benefit your credit score in two ways. First, it helps establish a history of making on-time payments — a key signal lenders look for when loaning money to borrowers. It also adds to your credit mix, by adding another type of credit to your profile.
When you pay a loan off and eliminate your debt, you may think your credit score would increase. And while paying off debt is good for your credit profile in the long run, you should expect your score to drop slightly after paying your debt down — especially if you're paying off your only loan.
Once your loan payments are no longer active on your credit report, your score might drop temporarily since your credit mix might decrease. But continuing to practice healthy habits — like paying down your other accounts and credit cards on time each month, will quickly help your score rebound.
What Happens to Your Credit If You Pay Off a Loan Early?
If you have enough money to pay off a loan, you may want to pay it off early. While this may be a smart move for your finances, here are some pros and cons to consider:
Less debt hanging over your head. The real benefit is obvious — you’re eliminating debt sooner, so you can focus on other financial goals. This can be a huge milestone emotionally, and worth considering if your debt has held you back in the past.
You can put money towards other debt. If the loan you’re ready to pay off is only part of your debt, paying off one account early can help you shift gears to focus on your next debt.
You could save on interest. Depending on your loan terms, you might save on interest if you pay off your loan sooner. This isn’t always the case, though.
Your credit mix may decrease. If you only have one loan, paying it off early is likely to ding your credit score in the short-term, since you’ll have less of a mix of credit on your credit report.
You’ll have no or fewer monthly payments reported. Making on-time payments on a loan or credit account each month helps demonstrate you’re a responsible credit user. With no or fewer monthly payments showing up on your credit report, your score might drop slightly.
You might be hit with an early-repayment fee. Some lenders charge you if you pay off a loan early, especially if they’ll miss out on interest. Be sure to check your loan terms before paying off the rest of your debt.
Pay Off Debt Early or Continue Making Payments?
Whether or not you decide to pay off your loan early is a personal choice that you’ll want to make on your own. If you want to keep the money you’ve saved to pay off your loan in a high-yield savings account, you can continue making regular payments, while earning interest on your money.
But if you think you’ll be tempted to spend this money or have other debts to focus on, paying off the loan may be a smart move.
Other Ways to Improve Your Credit
After paying off a loan early, you’ll want to ensure you continue to work on your credit. If you have credit cards, make sure you pay them on time each month, and try to use only 30% of your credit lines or less to keep your credit score healthy.
If you have few credit accounts after paying off a personal loan, you might consider adding a new credit card or line or credit to help boost your credit mix and offer you another way to establish regular monthly payments.
Courtney is a professional writer, editor and financial literacy enthusiast. You can find her writing on CNET, Investopedia, The Motley Fool, Yahoo Finance, MSN and The Balance. She spends her free time exploring different cities across the globe or enjoy some downtime with her two cats and one dog.