Paying off loans may not improve credit scores
Confusion abounds about how paying off an installment loan -- and paying it off early -- impacts your credit rating.
This post comes from Deanna Templeton at partner site Credit.com.
With credit playing such a huge factor in your financial future, it's no wonder we look for ways to maximize our credit scores. One common strategy for building your credit scores is to pay off credit card debt. It can give your credit scores a nice boost, especially if you're carrying a large balance.
It may seem logical, then, to assume that the same strategy must apply to other types of accounts -- like a car or home loan, for example. And if you follow this theory, paying a loan off early might sound like a great strategy for building your credit scores.
Unfortunately, you may be making yourself less creditworthy, according to scoring models.
When it comes to credit scores, there's a big difference between revolving accounts (credit cards) and installment loan accounts (i.e., mortgage, student loan). Paying an installment loan off early won't earn you any additional credit score points, and keeping them open for the life of the loan may actually be a better strategy for your credit scores. Let's take a look.
Credit cards vs. installment loans
Credit cards are revolving accounts, which means you can revolve a balance from month to month as part of the terms of the agreement. And even if you pay off the balance, the account stays open. A credit card with a zero balance (or a very low balance) and a high credit limit is very good for your credit scores.
Installment loan accounts are very different. An installment loan is a loan with a set number of scheduled payments spread over a predefined period of time. When you pay off an installment loan, you've essentially fulfilled your part of the loan obligation -- the balance is brought to $0, and the account is closed.
This doesn't mean that paying off an installment loan isn't good for your credit scores. It is. It just doesn't have as large of an impact because the amount of debt in individual installment accounts isn't as significant a factor in your credit scores as credit utilization is.
Now that we've clarified the difference between credit cards and installment loans, let's consider what happens to your credit scores when you pay off an installment loan, and whether or not it's a good idea to pay the loan off steadily over time or to pay it off early.
Paying off an installment loan affects your credit scores in a couple of ways:
Number of accounts with balances. The number of accounts with balances is one of many factors in your credit scores. When you pay off a loan you'll have one less account with a balance, which is good for your credit scores.
Types of credit and length of credit history. Credit scores love to see a number of different types of credit accounts, from auto loans and home loans to student loans and credit cards. It shows that you're able to manage different types of credit, and that's good for your credit scores. Credit scores also like long credit histories and well-aged accounts.
When you pay off a loan, the account is closed. So how does this affect your credit scores?
A common misconception is that when you close an account, the type of account and how long it was open are no longer considered in the score calculation. This is a little misleading because credit scores -- the FICO score in particular -- actually factor in both open and closed accounts.
The confusion exists because closed accounts will eventually fall off your credit reports, but not for quite a while. Closed accounts with late payments remain on your credit reports for seven years, and if the account was in good standing and paid as agreed, it can actually remain in your credit reports for up to 10 years.
Paying off an installment loan early. If you're thinking about paying off an installment loan early, keep in mind that credit scoring models like to see open, active accounts with a solid history of on-time payments. Paying off an installment loan early will most likely not hurt your score, but leaving it open and managing it through the term of the loan shows that you can manage and maintain the account responsibly over a period of time -- which is very good for your credit scores.
Paying off a loan and eliminating debt, especially one that you've been steadily paying off for an extended period of time, is good for both your financial well-being and your credit scores. But if you're thinking of paying off a loan early solely for the purpose of boosting your credit scores, don't do it. Instead, pay it off because you're looking to save money on interest payments or because it's what's best for your financial situation.
More on Credit.com and MSN Money:
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