It's always best to pay off a loan as soon as you can, isn't it? Not necessarily. There are several reasons you may not want to pay off your loan early, including the effects on your credit score.
The obvious reason for early payoff is interest savings. By paying your loans off early (especially large ones), you can save substantial interest charges. Some loans discourage early loan repayment by charging penalty fees. Know the terms of your loan and include these fees in your calculations when deciding whether to repay a loan early.
When assessing early loan repayment, follow two trains of thought. How will this affect my credit score, and is early loan repayment the best use of my money?
Consider your credit score first. Five factors influence your score – on-time payments, amounts owed/credit utilization (the amount of your available credit that you are using), length of credit history (including average age of accounts), types of credit used, and new credit applications. You can check your credit score and read your credit report for free within minutes by joining MoneyTips.
Surprisingly, paying off a loan early can be a negative for several factors. You'll have fewer on-time payments to register and you'll reduce your average age of accounts. If that was the only loan you had, you'll also reduce the types of credit you're using.
The effect on credit utilization depends on your other debts. If you have another small loan in good standing and several credit cards with low balances and high credit limits, you're fine. If your only other debt is a single credit card that's near the limit, your credit score will suffer.
If the loan was the only debt you had, and you use no credit for a significant time, your credit score will drop – or worse, you may become "unscoreable." This means that your recent risk factors are unknown. Did you stop using credit over the last six months because you have plenty of money and don't need credit, or did you lose your job and spend the last six months living in a cave off the grid? Credit scoring algorithms may not know the difference.
You may have overriding financial goals that define your loan payment plans. Are you skimping on retirement contributions? Do you have higher interest debt that you need to pay off first? Do you have an emergency fund? That extra loan payment may be better applied to these other purposes. At the very least you should build up a suitable emergency fund buffer to prevent you from taking on unnecessary high-interest debt in the future.
Credit card balances are a different story. While it's important to pay your bills on time to avoid damage to your credit score, it's generally best to pay the bill in full each month – or as much as you can afford to pay. Carrying a balance increases your credit utilization, which in turn lowers your credit score.
Typically, credit card debt is the highest interest debt that most consumers hold. Instead of making an extra payment on an auto loan or student loan, you can redirect that money to paying down credit card debt and simultaneously improve your credit score and save on total interest charges.
Before you decide to pay off a loan early, consider the other possible uses of that extra payment. You may be able to help your credit score and come out ahead financially by putting your excess funds to better use.
If you want to reduce your interest payments and lower your debt, join MoneyTips.