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Paying off debt to build credit is a pretty well-known strategy. It can help improve your credit score, especially if you’re carrying a large balance on your credit cards. So if you have other types of debt, like car or home loans, paying off those accounts might seem like a step in the right direction.

But here’s the thing—having a mix of accounts in your credit history is goodfor your credit score. You’ll actually want to have a good mix of revolving and installment loans. So does paying off a loan early hurt credit?

Does Your Credit Score Drop When You Pay Off Debt?

Unfortunately, paying off non-credit card debt early might make you less credit-worthy according to scoring models. When it comes to credit scores, there’s a big difference between revolving accounts (such as credit cards) and installment loan accounts (such as a mortgage or student loan).

Paying an installment loan off early won’t improve your credit score. It won’t necessarily lower your score, either. But keeping an installment loan open for the life of the loan could help maintain your credit score.

Credit Cards vs. Installment Loans

Credit cards are revolving accounts, which means you can revolve a balance from month to month as part of the terms of the agreement. Even if you pay off the balance, the account stays open. A credit card with a zero balance—or a very low balance—and a high credit limit is good for your credit score because it helps lead to a low credit utilization rate.

Installment loan accounts affect your credit score differently. An installment loan has a set number of scheduled payments spread over a predetermined period of time. When you pay off an installment loan, you’ve essentially fulfilled your part of the loan obligation. The balance is brought to $0, and the account is closed.

Does Paying Off a Loan Build Credit?

Paying off an installment loan as agreed over time does build credit. In part, that’s because 35% of your credit score is based on timely payments. And if you make timely payments for five or more years on an installment loan, that’s a lot of goodwill for your credit score.

Types of Credit and Length of Credit History

Credit scores are typically better when a consumer has had different types of credit accounts. It shows that you’re able to manage different types of credit. Your credit mix actually accounts for 10% of your credit score.

The age of your credit impacts your credit score. It accounts for around 15% of your score. Eventually, closed accounts fall off your credit score, which can reduce the age of your overall credit—and subsequently, your credit score.

Does Paying Off a Loan Early Hurt Credit?

If you’re thinking about paying off an installment loan early, take some time to think about it. Could you keep it open? It could be an active account with a solid history of on-time payments. Keeping it open and managed shows creditors that you can maintain the account responsibly over a period of time.

Consider other possible consequences of paying off a loan early. Before you pay off your loan, check your loan agreement for any prepayment penalties. Prepayment penalties are fees that are owed if you pay off a loan before the term ends. They’re a way for the lender to regain some of the interest they would lose if the account was paid off early.

Paying Off a Mortgage Loan Early

Sometimes paying off your mortgage loan too early can cost you money. Here are steps you can take to lighten those expenses:

  • When paying extra toward a mortgage each month, specify that the extra funds should be applied toward your principal balance and not the interest.
  • Check with the mortgage lender about prepayment penalties. These penalties can be a percentage of the mortgage loan amount or equal to a set number of monthly interest payments you would have made.
  • To help protect your future credit score, always make sure you have money set aside for emergencies and only pay extra if you can afford to do so.

Paying Off an Auto Loan Early

If you’re looking to pay your auto loan off early, there are several ways you can do so. When paying your loan each month, it might be beneficial to add an extra $50 or so to your payment amount. That lets you pay off the loan in fewer months and pay less in interest over the loan term. If possible, specify that the extra amount is to pay principal and not interest.

Another option is to make a single, large extra payment each year. Mark the payment as an extra payment toward principle. Do not skip another auto payment because you made this one, as your lender might consider you late if you do.

Repaying and Paying Off Student Loans

There are no prepayment penalties on student loans. If you choose to pay student loans off early, there should be no negative effect on your credit score or standing. However, leaving a student loan open and paying monthly per the terms will show lenders that you’re responsible and able to successfully manage monthly payments and help you improve your credit score.

The Bottom Line: Will Paying Off a Loan Improve Credit?

Paying off a loan and eliminating debt, especially one that you’ve been steadily paying down for an extended period of time, is good for both your financial well-being and your credit score. But if you’re thinking of paying off a loan early solely for the purpose of boosting your credit score, do some homework first to ensure it will actually help. If paying a loan off early won’t help your score, consider doing so only if your goal is to save money on interest payments or because it’s what’s best for your financial situation.

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Source: credit.com