Paying off a loan, whether it’s a car loan, personal loan, or whatever, is something to celebrate. This means you have one less monthly debt payment to manage within your budget and one less bill to worry about.
While paying off a loan is a positive thing, in some cases it could actually negatively impact your credit score. Fortunately, however, this impact should be minor.
How repaying a loan could impact your credit
To understand why paying off a loan can hurt your credit, you need to know what goes into calculating a credit score. There are five factors, each with a different weight:
- Your payment history, which reflects how well you pay your bills on time
- Your credit utilization rate, which measures the amount of your credit limit on all of your credit cards that you use at once
- The length of your credit history
- The number of credit accounts you recently requested
- Your credit mix, or the different types of accounts you have opened
Of all these factors, your payment history carries the most weight, followed by your credit utilization rate. The length of your payment history is in the middle, while recent credit accounts and credit composition carry the least weight.
Paying off a shorter-term loan, like a car loan, shouldn’t have a huge impact on the length of your credit history. But it could impact your credit mix – leaving you with a less healthy mix.
Generally speaking, credit card debt is considered a relatively unhealthy type of debt, although many consumers have regular credit card balances. Now let’s say you just paid off your vehicle and the only credit accounts open in your name are a bunch of credit cards. All of a sudden, that results in a less balanced and healthy credit mix – and therefore your credit score could take a hit once your car loan is gone.
To be clear, your score should only drop by about five points after the loan is paid off. This is because your credit mix has less weight than other factors in calculating your score.
How to increase your credit score
As a general rule, you shouldn’t be dealing a minor blow to your credit score. But if you want to increase that number, don’t worry too much about your credit composition. Instead, focus on your payment history and usage.
If you pay all of your incoming bills on time, it could improve your score. If you want your score to rise quickly, try paying off some of your existing credit card debt as this could instantly lower your usage rate, thereby increasing your score.
Paying off a loan is an important step to be happy about. Your credit score may take a little hit in the process, but it’s just a quirk of the way scores are calculated, and it’s not something that should keep you awake at night or cause you a unnecessary stress.
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