Are you about to make your last car loan or lease payment, or do you have some extra cash sitting around and are considering paying off your loan early? Or, have you already paid off your car loan and your credit score didn’t exactly respond in the way you expected?
Many people expect that their credit score will increase after paying off a car loan. This certainly makes sense — after all, isn’t paying off a car loan a responsible credit behavior?
While this is certainly a sign of financial responsibility, a car loan payoff doesn’t always have a favorable effect on the borrower’s credit score. The reasons for this have to do with how the FICO credit scoring formula works, and how a paid-off loan affects the calculation. With that in mind, here’s what you need to know about what to expect once your last payment is made.
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The short answer
Generally speaking, when you pay off a car loan (or lease), your credit score will take a mild hit. In a nutshell, the FICO credit scoring formula, the most commonly used scoring method by lenders, considers an almost-paid-off loan to be a superior credit item as compared with a loan you’ve already paid off.
However, like most personal finance topics, there’s a lot more to it than that. In the next section, we’ll take a closer look at why paying off a car loan could cause your credit score to drop.
Credit scoring 101
To understand how paying off a car loan can affect your credit score, it’s important to have a basic knowledge of what information your FICO® Score is based on. While the exact FICO formula that is used to determine your credit score is a well-guarded secret, we do know the five categories of information it considers, and the respective weight given to each one:
- 35% of your FICO® Score comes from your payment history. If you pay your bills on time, it will help this category, and things like late payments, charge-offs, and collection accounts hurt you.
- 30% of your score comes from the amounts you owe. This doesn’t necessarily refer to the total dollar amount of your debt, but puts most of its emphasis on the amounts you owe on your credit cards and revolving accounts relative to your credit limits, and the amounts you owe on your loans relative to their original balances. It’s also known as your credit utilization ratio.
- 15% of your score comes from the length of your credit history, which refers to the age of your oldest reported account, the average ages of all of your accounts, and other time-related factors.
- 10% comes from new credit, which means new credit accounts you’ve opened, as well as times you’re applied for credit (hard credit inquiries).
- 10% comes from your credit mix, which refers to the various types of credit accounts you have. The idea is that creditors want to see that you can be responsible with all types of credit, not just one or two.
How paying off a car loan could affect your credit score
With the categories of FICO information in mind, there are a few reasons why paying off your car loan could adversely affect your score.
The “amounts you owe” category is the biggest one that is affected. Specifically, your loans never have as much positive impact on this part of your credit score than when they’re almost paid off. In other words, if you only owe 1% or 2% of your original balance, it’s a major positive factor (assuming the loan is paid on time). After you pay the loan off, you lose this positive factor — the status changes to “paid loan” on your credit report.
Your length of credit history category could also possibly suffer, especially if your car loan was originated more than a couple of years ago. After all, paying off your loan can eliminate an established account from the calculation. Among other things, this portion of your score considers the average age of all of your reporting (active) credit accounts, so if a paid-off loan causes your average to decrease, it could certainly be a negative factor.
Finally, although it isn’t a major part of the formula, eliminating a car loan could hurt the “credit mix” portion of your score unless you have any other active car loans on your credit report. In other words, if you have a car loan and a few credit cards, paying off your car loan eliminates the only installment debt you had, thereby reducing your credit mix. According to FICO, the credit mix category is most influential for people who have credit files that are relatively new, or that don’t have too much other information, so this could be a larger impact if you’re in one of these groups.
Any credit score drop is likely to be minimal
Having said all of that, the credit score drop that results from paying off a car loan is likely to be quite small. I’ll share my recent personal example. I monitor my own credit closely, and recently finished paying a 36-month car lease. As soon as the account was updated to “paid loan” on my credit, my FICO® Score dropped by 4-6 points, depending on which of the three credit bureaus I checked.
To be clear, every situation is different. The impact of paying off a car loan is likely to be small, but it’s important to emphasize that the effect on your credit score could be significantly different from mine. For example, if you have just one or two other items on your credit report, or if your credit file is relatively young overall, most reports indicate that paid-off loans can cause a bit more of a dip in your credit score. On the other hand, if you have many other accounts in good standing, the effect of a paid-off car loan can be extremely minimal, if anything at all. Or, if you have a long-established credit history and most of your other active accounts are even older than your car loan, paying your loan off could potentially improve your length-related scoring factors and could result in a small increase.
The bottom line is that nobody knows exactly how the FICO® Score will react to any given change, and the absence of your car loan will be taken into account in combination with the other items on your credit report. In short, while the general result of a paid-off car loan is a small drop in credit score, there’s no one-size-fits-all rule, and you won’t know the exact impact of paying off your car loan until it’s already done.
View more information: https://www.fool.com/the-ascent/credit-cards/articles/what-happens-your-credit-score-if-you-pay-off-car-loan/