Recently, a friend of mine asked me if he should pay off his auto loan he had acquired years ago. While the interest rate on the loan is very low, less than 3%, he wanted to be free of debt and felt tempted to finish making monthly payments for the loan. He makes good income and is very disciplined about expenses, so paying the remaining balance would not cause any financial burden to him, and neither would maintain the monthly payments. His main concern was the impact on his credit.
I talked him out of it.
While it may be shocking to you, paying off an auto loan, or any installment loan for that matter, is bad for your credit.
As I have mentioned before, 10% of your FICO credit score is determined by your mix of credit. Most of your credit accounts should be credit cards, so in order to improve in this department, you need to have installment loans. Examples of installment loans are auto loans and mortgage loans. If you are a couple of years out of college like I am, you probably have not bought a house yet. More likely, you’d have a student loan or an auto loan.
If your credit profile consists of credit cards only, adding an installment loan will boost your FICO credit score in the long run. Adding a second installment loan would help further, but not as much as the first. The score improvement is due to the mix of credit. So naturally, closing your installment loans will take away the score increases.
Wait, but why would paying off my debt be bad for my credit? It doesn’t make sense.
Think about it.
Good credit indicates good debt management habits. This has little to do with whether you have the financial resources to pay off the debt. You can be a billionaire with lousy credit if you miss credit card payments. And you can flip burgers and have stellar credit if you keep making payments on time.
When you open a $20k auto loan and make monthly payments on time, what this implies to lenders, credit-wise, is that you are able to make loan payments consistently. The loan amount does not matter for your credit. Remember that when you apply for credit, you have to declare your income. Whether you have the financial resources to pay off the debt will be determined from the declared income; credit does not play a role in this.
Closing installment loans means you will no longer make payments on the loans. Lenders will not know if you can handle making monthly payments toward your installment loans, and therefore, your credit will be damaged.
That’s why I advised my friend against paying off his auto loan early, and also why I chose the longest duration for my auto loan when I applied for the loan earlier this year. If you care about credit and have installment loans with reasonable rates on file, do not hurry to pay them off.
Let me know if you need further explanation.