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Why paying off your loan is bad for your credit

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HiLine
Blogger

Why paying off your loan is bad for your credit

I recently posted this on my personal finance blog: http://hiepsfinance.com/2014/11/15/why-paying-off-your-loan-is-bad-for-your-credit/

 

For those that do not follow my blog, I would like to share an excerpt with you since it may clear up some confusion on this topic.

 

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. You ask? 

 

But 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 then; 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.

 

Message 1 of 49
48 REPLIES 48
MarineVietVet
Moderator Emeritus

Re: Why paying off your loan is bad for your credit


@HiLine wrote:

I recently posted this on my personal finance blog: http://hiepsfinance.com/2014/11/15/why-paying-off-your-loan-is-bad-for-your-credit/

 

For those that do not follow my blog, I would like to share an excerpt with you since it may clear up some confusion on this topic.

 

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. You ask? 

 

But 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 then; 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.

 


It does seem as if FICO 08 is quite a bit more sensitive when it comes to no installment loans reporting.

 

For me though being debt free is always better. A score is secondary. And I thought that long before I started finally seeing higher scores.

 

But that's just me. I can't and won't say someone else is wrong if they want to keep an account open.

Message 2 of 49
Anonymous
Not applicable

Re: Why paying off your loan is bad for your credit

I'm wondering- I have 2 students loan and 1 auto loan, my auto loan is at the end of the 48 month term actually I have like 3 payment left but I also am on the road of homebuying will paying off this auto cause a lot of damage even with the student loans reporting ?? 

Message 3 of 49
jamie123
Valued Contributor

Re: Why paying off your loan is bad for your credit


@Anonymous wrote:

I'm wondering- I have 2 students loan and 1 auto loan, my auto loan is at the end of the 48 month term actually I have like 3 payment left but I also am on the road of homebuying will paying off this auto cause a lot of damage even with the student loans reporting ?? 


You want to pay the auto loan off before you apply for a mortgage. You will still have the student loans reporting and they are installment loans so your scores shouldn't be affected.

 

The auto loan if NOT paid off would count towards your DTI ratio. In other words, a lender would subtract your monthly auto loan from the size of the monthly mortgage payments you would qualify for.


Starting Score: EQ 653 6/21/12
Current Score: EQ 817 3/10/20 - EX 820 3/13/20 - TU 825 3/03/20
Message 4 of 49
Anonymous
Not applicable

Re: Why paying off your loan is bad for your credit


@jamie123 wrote:

@Anonymous wrote:

I'm wondering- I have 2 students loan and 1 auto loan, my auto loan is at the end of the 48 month term actually I have like 3 payment left but I also am on the road of homebuying will paying off this auto cause a lot of damage even with the student loans reporting ?? 


You want to pay the auto loan off before you apply for a mortgage. You will still have the student loans reporting and they are installment loans so your scores shouldn't be affected.

 

The auto loan if NOT paid off would count towards your DTI ratio. In other words, a lender would subtract your monthly auto loan from the size of the monthly mortgage payments you would qualify for.


I am really hoping paying it off doesnt hurt my scores if so I will drag it out as long as I can, I am a mortgage processor and I know if you have 10 payments or less on any debt it is NOT counted in your DTI.. I just don't want paying it off to hurt me.. 

Message 5 of 49
android01
Valued Contributor

Re: Why paying off your loan is bad for your credit

Also remember that even if your installment loan is paid off and closed, it will stay on your reports for 10 years and still count in FICO scoring.  

EQ Fico 8 - 850
TU Fico 8 - 850
EX Fico 8 - 850
Message 6 of 49
Anonymous
Not applicable

Re: Why paying off your loan is bad for your credit

That's what thought but I have been hearing so many horrible stories about how people scores dropped after they paid off something... 


@android01 wrote:

Also remember that even if your installment loan is paid off and closed, it will stay on your reports for 10 years and still count in FICO scoring.  


 

Message 7 of 49
Anonymous
Not applicable

Re: Why paying off your loan is bad for your credit

I agree! Ever since I took out a springleaf financial loan my scores have improved. Im wondering how an auto lease affects it though? I have leased for more than 3 years because I like getting a new car at the end of a lease. Will that affect me negatively?

Message 8 of 49
Stylez
Valued Member

Re: Why paying off your loan is bad for your credit

It makes no sense. If a lender sees that you took out a loan and paid it off, why would they be under the impression that they are in the dark about your ability to make monthly payments towards your installment loan? Installment loans stay on your report for like 7-10 years even after they've been paid off. So unless you paid off your loan and didn't take another one for 7-10 years it makes no sense that paying off a loan can hurt your credit.

Message 9 of 49
Anonymous
Not applicable

Re: Why paying off your loan is bad for your credit


@Stylez wrote:

It makes no sense. If a lender sees that you took out a loan and paid it off, why would they be under the impression that they are in the dark about your ability to make monthly payments towards your installment loan? Installment loans stay on your report for like 7-10 years even after they've been paid off. So unless you paid off your loan and didn't take another one for 7-10 years it makes no sense that paying off a loan can hurt your credit.


Stylez I said the same thing- But I have been seeing a trend on the forums about it... Even though I got other installment loans (student loans) I so scared to pay off my car becaue I can't afford to lose the points because I am trying to buy a home soon... every point counts

Message 10 of 49
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