Focus on finances -- not your credit score -- when repaying a loan
By Jeremy M. Simon | Published: April 27, 2010
Credit Score Report
Dear Credit Score Report,
I only have one bank loan so far and that's my car loan. Is it better to pay it off over a five year duration or is it better to pay it off as soon as possible? Which would help my credit score more? Thanks. -- Tulsi
The decision to repay your car loan immediately or over time should be based on strengthening your finances overall -- not on improving your credit score, experts say.
If you have enough money on hand and the terms of your loan permit it, an immediate repayment could be the best decision for your finances: By paying off your loan quickly, you're likely to save money on interest payments. The resulting change in your credit score, however, isn't so clear. "If you can pay off the loan early, it could certainly help your peace of mind, but it won't necessarily help your credit score," says Rod Griffin, director of public education for credit bureau Experian.
Credit industry experts acknowledge that it's difficult to predict the impact of an early payoff on your credit score. The widely used FICO scoring system rewards certain borrowing behaviors, such as making on-time bill payments and maintaining low debt levels. "Paying off an installment loan extra-fast might help the borrower's FICO score in some areas, such as reducing his overall debt obligation," FICO spokesman Craig Watts says. However, your debt-to-limit ratio (which compares debt levels to available credit) isn't the only factor used to calculate your credit score -- or even the most important. As a result, quickly repaying your debt "can also detract from his score by reducing the number of months that the lender has reported his loan to be paid-as-agreed," Watts says. "Remember, payment history has the greatest influence over a person's FICO score," he adds.
While the impact on your credit score is unclear, to determine the impact on your wallet, here are a few things to consider:
- How early is early? The quicker you repay that debt, the fewer interest payments you'll end up making. That's why repaying a debt five years early will save you lots more money than repaying it five months early.
Is there a penalty for paying the loan off early? "One question you might ask is whether there is an early repayment penalty," Griffin says, noting that such a penalty could make it cost more to repay your auto loan early.
- Do you have other debt to pay off? You say you don't have any other bank loans right now, but does that include credit cards? Are you thinking about getting any other loans in the near future? If so, the extra money you saved in interest payments could come in handy. "By paying off the loan early, you could use the funds that would otherwise go toward your car payment to reduce your other debts, particularly credit cards," Griffin says. Reducing those debts would improve your utilization ratio and, in turn, your credit score.
In other words, any extra cash you save now can be applied to making on-time payment to reduce any future debt -- and that will help your credit score in the long run.
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