Next month will be the final month of my auto loan's term and I'm terrified of what will happen.
Whether it's auto loan debt, student loan debt, or a mortgage, most of us have considerable loans to our names. It's important to understand the consequences of how we handle this debt.
From missing payments to paying off the balance early to making our final payment, there are long-term repercussions you should know about.
What Happens When You Pay Off a Loan
First, let's cover the obvious... you get to stop making loan payments.
This is a massive benefit because your personal cashflow immediately increases by the previous amount of your loan payment. You can easily funnel that entire amount into something more productive like investments or tackling other high-interest debt.
Don't get me wrong, I'm very excited to increase my monthly investing because of this new cashflow.
But there is a long-term cost that comes as a result of paying off a loan too. And though it might not be immediately impactful, it can take more time to correct and get back to normal.
The long-term cost is your credit score.
The Impact on Your Credit Score
A few things worry me about paying off this long-term loan.
I know as a result my credit is going to drop and there's nothing I can do about it. And most of all the timing is absolutely not ideal as I'm looking to get a new mortgage and apply for new credit cards soon. So my credit is going to be checked and potentially be lower than normal when that happens.
At a high level, here's what hurts your credit score when you pay off a loan:
- Your total number of accounts decreases
- You lose an aged credit account which can decrease age of credit
- You lower your mix of credit assuming it was your only car loan
Let's get into it.
Decreasing Number of Accounts
Creditors want to see that you manage credit responsibly and one metric they measure is how many loans and credit accounts you have.
From their perspective, someone with many active accounts has more experience compared to someone with only a few open accounts.
The problem with paying off a loan is your account is then closed!
It will no longer be counted as an active account and as a result will decrease your total account number, lowering your credit score as a result.
Closing accounts is one of the most common credit mistakes.
The only way to really counter this effect is to have a significant number of accounts, to begin with. But that can take time as rapidly opening a lot of accounts will also negatively impact your average age of credit which would also lower your score.
So let's talk about that.
Decreasing Age of Credit
Lenders and creditors want to work with trustworthy borrowers who present the least risk.
A borrower who has only had a credit card for a year is riskier than someone who has had a card for 30 years and made every single payment on time.
To measure this, your credit score factors in how long you have had your accounts open for. Depending on the FICO score version being used it can be weighed differently. Generally, the most important factors are the age of your oldest account, the age of your newest account, and the average age of all accounts combined.
What happens when you finally pay off a loan, is that this account that you have had for a few years is now closed and stops being included in the average age of your accounts.
If you are actively working on your credit, opening new credit cards, buying real estate, and getting new mortgage loans... you probably have a lot of new credit and as a result, will see a big decrease in the average age of your accounts.
Again, the best way to counter this is to have a large number of accounts that you keep open for as long as possible.
This way they will bring up your average and as loans are paid off, the average age will still be pretty high given the numerous aged lines of credit you have maintained.
Decreasing Mix of Credit
Lastly, another factor creditors pay attention to is your mix of credit.
A borrower that has experience with many different types of credit and various loans is likely more experienced with credit and knows how to handle and repay their debt.
Compare this to someone who is taking out a loan for the first time, creditors do not have as much information about this borrower. This borrower may be more likely to stop making payments after a certain amount of time.
Because of these factors, it's better for us to try and maintain a good mix of credit in addition to having many accounts.
A mix of credit means a combination of installment loans and revolving credit.
This means all of our accounts aren't just credit cards.
Ideally, we have credit cards, lines of credit, or maybe a home equity line of credit. These are all considered revolving credit. The balance changes over time and can go up or down and there's not always a set term or amount of payments associated with the credit line (although HELOCs usually do have a specific duration).
In addition, we need installment loans to prove to creditors our wide experience with credit and debt.
Installment loans are things like auto loans, student loans, and mortgages. These have set payment terms, usually specifying a portion of the loan's principal balance and interest due every month. The balance typically doesn't go up in the same way a revolving credit line can.
Wrapping Up
Ultimately, credit scores can be complicated, but we know the factors that go into them so we can always plan ahead and minimize negative consequences.
Your score might not always go down, but it's important to understand the components of your score and how these different factors will be affected.
For better or for worse you will eventually pay off each of your loans, and it's best to think about these consequences when that happens. It's also because of these points that I generally tend to not pay off debt early, along with other reasons like the opportunity cost of that capital.
Good luck with your future credit score, and congrats on paying off your loan!