This is one of the scoring myths that may be hard to believe. When you pay off an installment loan, there may be a slight positive impact to your FICO credit score, but very little. And, in many cases your score won’t change at all.
Installment loans are usually auto and mortgage loans, and you pay a fixed amount per month for a specified number of years. The loan amount is usually thousands of dollars, secured either by your car or home. Installment loans don’t have a large impact on your score, since borrowers tend to pay these loans before their credit cards. They don’t want to lose their home or car. The amount of the loan compared to the balance remaining, does not impact the score as it does for credit cards, because it takes years to pay off the loan and reduce the amount owed. For a mortgage loan, there is very little reduction in principal for many years.
When you pay off an installment loan the account balance is zero and the account is considered closed on your credit report. This account is now part of your credit history. An open account paid on time, does more for your score than a closed account. It shows that you are currently paying on time.
What impacts your score is not paying your installment loans on time, how many days or months you have been late, and how many times you have been late. For example, being 90 days past due twice, impacts your score more than being 30 days late once.
If you are concerned about your score, paying off your installment accounts early won’t have much impact. Depending upon the terms of your loan, an early payoff can save you money in interest charges. Some loans have penalties for early payment, such as car loans. Mortgages usually don’t, but you pay most of the interest in the early years and pay toward the principal near the end of the loan. Some try to make additional payments toward principal each year to reduce the loan time frame.
Credit card debt
Credit card debt impacts your score more than installment loans. Credit cards are usually unsecured debt, unless you have a secured card. If your card is unsecured, you agree to pay for your purchases, but the credit card issuer can’t repossess the merchandise. Not only does your credit card payment history impact your score, but also how much of your available credit you have used. The closer your balances are to your credit limits, lowers your score. You are considered more risky, because you are using more of your credit that you can’t pay in full.
If you have credit card debt, it is best to use the extra money for that, instead of for the installment loan. Credit card interest rates are much higher than installment loan interest rates. If you don’t have credit card debt, consider paying down your installment loans or put money into savings or retirement.
Credit Expert, John Ulzheimer, is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. Follow him on Twitter here.