Why paying off your loan is bad for your credit

[HiLine]

I would like to take this opportunity to remind everyone that it doesn't matter if you think the FICO scoring system is intuitive or not.

The reason FICO is so popular is because it works. FICO scoring systems quantify credit management ability, and how exactly they do that, nobody except the FICO statisticians knows. If the statisticians, upon observing and analyzing historical data, determine that the credit management ability of someone that is paying an installment loan is better than that of someone that is no longer paying an installment loan, everything else being equal, then they assign a negative sign to the "not having an open installment loan" parameter. Doesn't matter if you agree or not. Be a statistician, work for FICO, and present your case if you disagree with the model. Otherwise, without actual data and deep expertise, your claim isn't any good.

[HiLine]

Let me try a different angle.

Suppose without an installment loan, your FICO score is 700. Ignore the impact of time for our purposes.

Now if you add an installment loan, you get 2 boosts to your score.

1. The fact that you have an installment loan on your credit report, equal 15 points

2. The fact thay you are making on time payments on the loan, equal 10 points

So your score , with the boost from (1) and (2) is now 725.

Then you pay off your installment loan. So you only have (1) left. Compared to your original score of 700, you have a boost of 15. So your score is 715.

The logical way of thinking about this is: You're either getting a 15 point boost, or a 25 point boost.

The illogical way of thinking about this is: If you're getting a 25 point boost, you're not getting anything. If you're getting a 15 point boost, you're getting penalized.

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Does this remind anyone of high school?

If you work hard, you either get an A or a B. A is for "excellent" and "B" is for good. Heh, that's the logical way of thinking. 

What's the illogical way of thinking? If you get an A, that's a given. If you get a B, that's a penalty.

What's wrong with this kind of thinking is that it ruins the whole reward system. Nobody complains about getting an A for being excellent, but everyone complains about a B when they are only good. What would they rather see? Everyone getting an A?

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So why should your credit score be higher when you are paying an installment than when you have stopped paying an installment loan? 

The same reason your credit score should be higher when at least one of your credit cards is showing a positive balance than when your all credit cards appear inactive. Try closing all your credit cards and see if that has the same impact as paying off all your installment loans.

All right, I'm kidding. Don't do it. It will be bad for your credit.

I am glad this thread has attracted this much attention. I do not plan on further elaborating on the issue, since it's getting old and I'm spending too much time on this forum (yet again!). If someone else feels like taking over, please go ahead. I cannot be the only person that gets this. Many posters have been on the forum longer than I have, and have read and thought more than I have. Hopefully they can help you out. 

Cheers,

-HiLine

[Anonymous]

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@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.

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The utilization percentage is very iffy when paying off debt. Right now, one of the CB's stimulator suggests that I pay off my installment loan to increase my FICO score. I will be taking the next 2 years to PIF. It may negatively affect my scores, but I don't care. It's more important to be debt free.

[vanillabean]

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@beautifulblaquepearl wrote:

I don't care. It's more important to be debt free.

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Being debt-free is well overrated for non-card stuff. It doesn't matter whether you have paid off your house, if your retirement or health isn't in order.

[Anonymous]

I can see why this would be true if you had a car loan for 5yrs and paid every month and suddenly an uncle dies and leaves u some money and u pay it off in month 7 that doesnt show you can manage money and be responsible for a long time, its great for you but probably seen as we still dont know if this person can manage money consistently by everyone else who views your credit.

[ccb2115]

This makes me so nervous! I had a student loan that I have been paying off since 2006. My latest balance was 651, so I decided to just pay it off and get it over with. MY TU score should be fine because I have another student loan reporting, but my EQ only has one other student loan that is already closed/paid off. I'm mostly worried about my EX score, as this now paid off student loan is the only installment loan reporting. I really don't want my score to drop 70+ points?!? 

[HiLine]

Ccb2115: typically the impact is not that significant. Not even close.

Stevez333: good point!

[HiLine]

Bump

[HiLine]

Another reason I just thought of for the need for a mix of credit: An auto loan is a secured loan, while a credit card balance is not.