Paying off a car loan can affect different consumers differently, but here’s an overview of what you need to know. Image source: getty images.
Are you about to make your last car loan or lease payment, or do you have some extra cash and are considering paying off your loan early? Or, have you already paid off your car loan and your credit score didn’t respond exactly the way you expected?
many people expect their credit score to go up after paying off a car loan. this certainly makes sense; After all, isn’t paying off a car loan responsible credit behavior?
While this is certainly a sign of financial responsibility, paying off a car loan doesn’t always have a favorable effect on a borrower’s credit score. The reasons for this have to do with how the FICO credit score formula works and how a paid 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.
the short answer
Generally speaking, when you pay off a car loan (or lease), your credit score will take a slight hit. Simply put, the FICO credit score formula, the most widely used scoring method by lenders, considers a nearly paid-off loan to be a superior credit item compared to 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 score 101
To understand how a car loan payment can affect your credit score, it’s important to have a basic understanding of the information your Fico Score® is based on. While the exact FICO formula used to determine your credit score is a closely guarded secret, we do know the five categories of information it considers and the respective weight given to each:
- 35% of your fico® score comes from your payment history. paying your bills on time will help this category, and things like late payments, charge-offs, and collections will hurt it.
- 30% of your score comes from amounts you owe. this does not necessarily refer to the total dollar amount of your debt, but rather places greater emphasis on the amounts you owe on your credit cards and revolving accounts in relation to your credit limits, and the amounts you owe on your loans relative to your original balances. 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 age 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 how many times you’ve applied for credit (hard credit inquiries ).</li
- 10% comes from your credit mix, which refers to the different 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 a car loan payment could affect your credit score
Given the categories of fico information, there are a few reasons why paying off your car loan could negatively affect your score.
The category “amounts you owe” is the most affected. Specifically, your loans never have as positive an impact on this part of your credit score as when they are almost paid off. In other words, if you only owe 1% or 2% of your original balance, that’s a major positive (assuming the loan is paid on time). after you pay off the loan, you lose this positive factor: the status changes to “loan paid off” on your credit report.
The length of your credit history category could also be affected, especially if your auto loan originated more than a couple of years ago. after all, paying off your loan can remove an established account from the calculation. Among other things, this part of your score takes into account the average age of all your reporting (active) credit accounts, so if a canceled loan causes your average to drop, it certainly could be a negative factor.
Finally, while not a major part of the formula, removing an auto loan could hurt the “credit mix” portion of your score, unless you have other active auto 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, 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 don’t have a lot of additional information, so this could have a bigger impact if you fall into one of these groups.
Any drop in credit score is likely to be minimal
Having said all that, the drop in credit score that results from a car loan payment is likely to be quite small. I will share my recent personal example. I monitor my own credit closely, and recently paid off a 36-month car lease. As soon as the account was upgraded to “Loan Paid” on my credit, my FICO® score dropped between 4 and 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 than mine. For example, if you have only one or two other items on your credit report, or if your credit history is relatively new overall, most reports indicate that paying off loans can cause a slightly larger drop in your credit score. On the other hand, if you have a lot of other bills up to date, the effect of a paid car loan can be extremely minimal, if 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 off your loan could potentially improve your duration-related scoring factors and could result in a small increase.
The bottom line is that no one knows exactly how the fico® score will react to any given change, and the absence of your car loan will be considered in combination with the other items on your credit report. credit. In short, while the general result of a paid-off car loan is a small drop in credit score, there is 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.