Why paying off your loan is bad for your credit

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.

My friend should not pay off his auto loan early.

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.

How does this make sense?
How does this 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.

Credit is a habit.

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.

-Richard

Advertisements

4 thoughts on “Why paying off your loan is bad for your credit

  1. This is the best explanation of why having a a mix of credit types increases the credit score. However, it still fails the common sense test. Would you prefer to extend your own money to a person earning a million and having millions in liquid assets or to some one who has a mix of loan types but is in debt to their eye balls? The logic in this article fails here: “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.” No one talked about “missing” a payment on a credit card. The explanation is having only having a credit card usage and no other loan types. Why should this person’s FICO score be marked down? The only logic is that credit rating agencies are in bed with banks.

    1. I think you, like most other consumers, misunderstand the purpose of credit. It does not by itself determine the outcome of your credit application. The other parts, including income, DTI, etc are no less important than credit. As i mentioned in the post, credit is not about how much money you have. It is debt management habit. A billionaire can have bad debt management habit, but that does not mean he will not be able to pay the debt. Banks need to loan out money to make revenue, and thoroughly reviewing each credit application to determine the riskiness of the lender is the most crucial part of their business. That’s why no bank will rely solely on credit reports or credit scores. So don’t sweat it if you’re a warren Buffett that can’t remember to pay your credit card bill each month to save his life! ;

      1. The falllacy in the argument that one needs to have a mix of loan types is the assumption that there is a difference in paying a monthly installment of different types of loans. In reality whether one pays off a credit card debt each month or a car loan, each act shows a responsible act. In my opinion whether it is repaying two credit card payments or one credit card and one instalment loan is of no consequence. This same illogical reasoning could be extended to saying one needs have a range of credit cards including Visa and Mastercard. The credit scoring system is a subtle way to encourage consumers to be dependent on debt and banks. The relationship between credit rating agencies and the banks are incestuous. Each benefits from the other. The poor consumer ends up holding the bag.

      2. There is a difference between paying credit card bills, the amount of which varies from month to month, and paying installments, the amount of which is fixed per period. There is no difference between having a visa or a mastercard for credit purpose whatsoever. Also, mix of credit is a FICO parameter. Other scoring models may not take it into account. It so happens that over time, FICO scores have become the most trusted. Nothing to do with consumer reporting agencies.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s