When you pay off a loan, your credit score should go up. The correlation between these two items has to do with the way credit scores are calculated. Paying off a loan helps boost your payment history and lower your total debt, both of which will boost your score. However, there are a few scenarios when paying off a loan will not help your score.
Factors
Credit scores are calculated based on five primary factors: your payment history, the amount you owe, the length of your credit history, new credit you have obtained and the types of debts you possess. Because scores rely on all of these factors, one action can have a multi-faceted impact on your score. For example, paying off a loan will reduce the amount you owe and improve your payment history. However, it may limit the types of debts you possess, affecting you in a negative way.
Considerations
Paying off a loan should do far more good to your score than bad. However, there are particular negative consequences to consider when you pay off a loan according to a schedule different from your original contract. When you repay a loan early or late, your lender may lose a portion of the profit it was expecting. Rather than reporting your loan as successfully paid off, the lender may actually report the debt as closed in a manner unsatisfactory to the lender. This can actually lower your credit score.
Example
One example of unintended credit consequences arises with a consolidation loan. When you consolidate debts, you are actually paying off a handful of loans at once with a new loan. All of these loans will likely be prepaid, which means you could actually face a large drop in your credit score despite paying down a number of your debts. Since you still have a new consolidation loan, your total debts owed did not go down. This example shows how paying down a loan may actually harm your score.
Solution
Anytime you are preparing to pay off a debt, ask your lender for a payoff quote. If the quote contains any type of fiscal penalty, the lender is warning you the payment is coming in an untimely fashion. You may be charged an additional premium to pay the loan off at this time, and your score may go down. If you know you face a penalty, contact your lender to ask when you should repay your debt to avoid the penalty.
Expert Insight
Whether your credit will be impacted by paying off a loan depends on the terms of your original loan contract. For example, federal student loans can always be repaid early without consequence. Many mortgage contracts are also open-ended. Know your contract to determine whether you will be penalized.
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