It might sound counter-intuitive, but paying off a car loan early could actually lower your credit score. This quirk in the credit scoring system can occur when you have too few active accounts or do not have other installment loans. However, you can never predict anything in the FICO scoring method, so consider the other benefits of paying off an auto loan, such as the money you save in the long run.
Why It Might Lower Your Score
Paying off an auto loan is never a negative, but it can actually have a negative effect on a credit score, because the FICO model does not factor in installment loans in the "mix of credit" category. Mix of credit is worth 10 percent of a FICO score. To get the most points, you should have several credit cards and a few installment loans. If this auto loan is your only active installment account, the lack of credit variety could outweigh any positive history on the account.
Considerations
Though paying an auto early could have a negative effect on your score, lenders might not care. If you have a clean credit history, they will only see positive accounts that were never late, which might outweigh any potential score drop. As long as your car loan agreement does not charge prepayment penalty fees, you save hundreds of dollars in interest charges.
Should Apply for an Installment Loan to Boost Credit?
Whether or not you should apply for an installment loan with the sole purpose of boosting your credit depends on what you plan to do with your credit score. If you have bad credit and need as many points as possible, an installment loan brings back to good credit faster, according to Liz Weston of MSN Money Central. Should you still have good credit even without an installment loan, taking one out could be a waste of money and hurt your credit. Applying for credit dings your score a few points as does taking on any new debt.
Tip
CreditNet reports that paying off a car loan could drop a score by 50 to 60 points. This can easily drop you out of the top tier of credit scores. If you plan on taking out a loan any time soon, such as a mortgage, it might be wise to apply while you still have the auto loan on record when you have a score over 760. However, factor in your debt-to-income and keep it as low as possible. Lenders usually want to see a DTI between 20 and 35 percent or lower before issuing a loan, even for borrowers with great credit.
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