Your auto loan is an important component of your credit history, and paying it off affects your credit score. The exact impact on your score depends on your overall credit use. Your credit score fluctuates depending on your financial activity, and is affected by everything from opening and closing accounts to missing a credit card payment.
Definition
An auto loan is a secured loan, which means there is an asset to guarantee repayment. The lender can repossess your car and sell it to regain some of its investment if you stop making payments. This is in contrast to unsecured accounts like credit cards that have no collateral. Lenders view secured loans as less risky, so they are more likely to be granted to borrowers with a marginal credit score than a new credit card. Your credit score is a three-digit numerical summary of your credit worthiness. The FICO score is the most commonly used source for credit reporting.
Effects
Your auto loan affects your credit score in the same way as your other accounts. By making your car payment on time every month you support the foundation for a good credit score. FICO states that payment history makes up 30 percent of a credit score. The Repair Bad Credit Report website explains that paying off your auto loan is not particularly helpful for your credit score because it doesn't affect your available credit lines. Your score is partially based on the ratio of credit available to you, to debt you owe. So, instead of paying off your auto loan early, it is more effective to pay down credit card debt.
Considerations
It may be a good idea to pay off your auto loan even if it doesn't raise your credit score. Compare the interest rate to your credit cards and other loans. Pay off the highest interest account first and channel the money you were paying monthly toward your other bills. This will raise your credit score in the long term as you maintain a good payment history and improve your credit used to credit available ratio.
Time Frame
Your auto loan only affects your credit score for seven years after payoff. Then it is dropped from your records. The account payment history prior to payoff will have less importance as time passes. FICO explains lenders place more importance on recent credit items than old ones.
Alternative
It may be smarter to refinance your auto loan than to pay it off. You may have gotten stuck with a high interest rate if you bought your car when your credit score was low. Philip Reed, a senior editor for the Edmunds automotive website, advises your monthly payment will go down and you may save thousands of dollars over the life of the loan if you rebuild your credit for several months and get refinanced by a new lender at a better rate. Pay the new auto loan on time to maintain your improved credit score.
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