Is paying off a car loan early hurting your credit? – Forbes Advisor

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If you’re nearing the end of your car loan term, you may be considering paying off the note early, but wondering if it will hurt your credit score.

Paying off your car loan early will hurt your credit score, but only in the short term, because having an open credit account that you regularly make payments on has a greater positive impact on your overall credit score. . However, there are also other factors to consider. Here’s what you need to know.

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How paying off your loan early affects your credit

Each time your credit history changes, such as the repayment of a loan, your credit score may drop slightly. If there are no defaults or bankruptcies in your credit history, this drop should be temporary and your credit score will rebound soon.

According to Experian, a consumer finance company, your car loan stays on your credit report for up to a decade after it’s paid off. So, as long as you are always on time with your payments, the loan will continue to have a positive effect on your credit history.

However, while the auto loan paid off will ultimately contribute to your credit score, having more positive credit open accounts has a greater impact than closed accounts. Lenders want to see how well you continue to pay off your debts now, not what you’ve done in the past.

Also, having an open auto loan and making regular payments helps if you’re trying to build a credit history or improve your credit score. If you don’t have a lot of credit accounts, a car loan will build your credit report and improve the diversity of your credit report.

Having a combination of accounts like credit cards and larger loans with fixed monthly payments can also help boost your credit score and make you more attractive to lenders.

When it makes sense to pay off your car loan sooner

There are times when paying off your car loan early is the right decision:

Savings

Most people decide to pay off their auto loan sooner because of the amount of money they save. However, this only applies with a simple, non-pre-calculated interest rate (more details below). A simple interest rate is calculated monthly based on how much you still owe, so if you pay off your loan early, you won’t have to pay interest that would have accrued on the rest of your loan.

Help your budget

You could ease the pressure on your monthly budget by paying off your car loan earlier, giving yourself more money for other necessities, or storing funds for a rainy day.

Avoid being underwater

If you owe more on your car than it’s actually worth, it might be worth paying it off early. If you have an accident and the car is completely destroyed, then you will have to repay the lender the value of the vehicle plus the negative equity.

Lower debt-to-income ratio

If you’re applying for a mortgage and need to lower your debt-to-income ratio (DTI) to get approved or qualify for a lower interest rate, paying off your car loan early could improve your chances. Your DTI is the total amount you owe each month compared to your monthly income. Lenders generally like a DTI of 43% or less, but most prefer ratios below 31%.

High rate car loan

If you have a car loan that matures in five years or more, you will have a lot of interest to pay over its life. Repaying the loan early can reduce the total amount that comes out of your pocket. Again, it’s important to make sure your lender hasn’t included a prepayment penalty.

When is it better not to repay the loan earlier

In some situations, it is better not to pay off your car loan sooner.

Penalty for prepayment

In addition to considering the effect that prepaying your car loan will have on your credit score, you should also check your financing documents to see if there is a penalty for prepaying your loan. Some lenders charge a penalty for prepaying your car loan. This would wipe out your expected savings.

The cost of these fees may exceed the interest you will have to pay over the remaining life of the loan. If so, it makes more sense to keep making your payments instead of paying earlier.

Identification of prepayment penalties

A lender can impose a prepayment penalty in several ways.

  • Penalties in percentage: This is the most common approach. The lender charges you a certain percentage of the remaining loan balance if you choose to prepay it. Thus, the amount of the penalty will depend on how long you have taken out the loan. The Truth in Lending Act requires that these penalties be disclosed by the lender, so read your loan documents carefully.
  • The rule of 78: This is a method used by some lenders to calculate interest charges on a loan. It forces the borrower to pay a greater portion of interest in the early part of a loan cycle, rather than the principal. This reduces the potential savings for you by paying off your loan sooner because the lender still receives the full amount of interest.
  • Pre-calculated loan: The lender calculates the total amount of principal and interest for the loan, and the borrower agrees to pay the total amount of principal and interest, regardless of how quickly the loan is repaid. While technically not a prepayment penalty, these types of loans mean that you won’t save money by repaying the loan early.

Low interest loan

On average, interest rates on auto loans tend to be lower than many other types of debt, especially credit cards. If you have a large card balance, paying it off makes more sense than paying off a car loan early. And if you got great loan terms when you bought your car, there’s really no benefit to paying it off early.

The loan is almost paid off

If you only have a few payments left, paying off your loan early won’t save you much interest. In this case, it is better to keep the loan and benefit from the boost to your credit score.

You want to sell the car

If you want to sell your car privately, having the title to the vehicle, which you get after paying off the loan, will make the sale easier.

You have budget constraints

You should not prepay your car loan if it puts you in a precarious financial situation. Emptying your savings account or making larger monthly payments than you can afford could make it difficult to cover unexpected expenses later.

What is the right decision?

It all boils down to a mix of the topics discussed above. You should consider your credit history, your credit score, the amount of interest you pay versus the amount you would save, your other expenses (current and future), whether you are applying for a mortgage and s whether or not there is a prepayment. sadness.

Alternatively, you can choose to refinance a high interest auto loan for one with a lower interest rate. If your credit score has improved or interest rates have dropped since you bought the car, refinancing may lower your payments and your credit score will continue to rise as you make your monthly payments at time.

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