Paying off a loan is a major milestone. Whether you’ve finally cleared your student debt, paid off a home improvement loan or own your car outright, making your last loan payment calls for celebration.
But before the balance hits zero, there are a few things to know and prepare for, especially if you’re considering paying off a loan early.
1. Your credit score may temporarily drop
You read that right: Paying off a debt can cause your credit score to drop.
The length of your credit history and your credit mix are two factors that affect your credit score.
Paying off an installment loan that’s one of your oldest accounts could cause a dip in your score by lowering your average age of credit, depending on the scoring model. FICO scores, which most lenders use, are calculated using both open and closed accounts, so paying off an installment loan shouldn’t lower your credit age. But VantageScore models may omit some closed accounts, which could shorten the length of your credit history.
If the loan was your only form of installment credit (as opposed to credit cards’ revolving credit), your score could go down because you’ll have a less diverse credit mix.
The good news is that this dip in your credit score is likely temporary. Also, your credit score may still be higher than it was when you took out the loan, particularly if you made on-time payments and used the funds to wipe out credit card debt.
Continue making on-time payments toward other loans and credit cards to strengthen your credit.
🤓 Nerdy Tip
If you paid off your loan without missing payments by more than 30 days, the account will show as closed in good standing on your credit reports. The account will remain on your credit reports for up to 10 years, so you’ll continue to benefit from the positive history. 2. You’ll have extra money in your monthly budget
Once the cash you used for loan payments is free, you can put it to work. Here are a few options:
- Start or add to an emergency fund. NerdWallet recommends working toward $500 and then striving for three to six months of living expenses.
- Pay off other high-interest debt. Putting extra money toward credit card or high-interest loan payments will help pay down that debt faster.
- Save for your next big goal. That could be a down payment on a house, your kids’ college education or a dream vacation.
3. Your debt-to-income ratio will drop
Your debt-to-income ratio is the percentage of your monthly income that goes toward debt payments. When you eliminate a debt payment by paying off a loan, this number will be lower — and that’s a good thing.
For example, say you earn $2,000 per month. If $500 goes toward a personal loan payment, and you spend an additional $300 on an auto loan payment, your DTI would be 40%. Once you pay off the auto loan, it will be 25%.
Lenders use DTI — among other factors — to determine whether you can afford the monthly payment on a new personal loan, mortgage or auto loan. The lower the number, the better.
4. You may qualify for lower rates
With a lower DTI ratio and a better credit score, you may qualify for a lower annual percentage rate on a new personal loan. Pre-qualify with multiple lenders to check and compare potential loan rates without hurting your credit score.
Shopping around for the best mortgage or auto loan may require a hard pull of your credit before preapproval, which can cause a temporary dip in your score. However, you can minimize the impact to your credit by seeking multiple loan preapprovals within a specific time frame (typically 14 to 45 days).
Paying off an installment loan may also put you in a better position to refinance existing loans or credit cards at a lower rate. Refinancing can lower your monthly debt payments and reduce the amount of interest you’ll pay over time.
What to do before paying off a loan early
You may be tempted to pay off an installment loan early to save on interest and get rid of the monthly payments. However, there are a couple of things to do before making plans to eliminate the debt ahead of schedule.
- Check your loan documents for prepayment fees. Some lenders charge a fee to make up for the interest payments they’d miss out on if a borrower pays the loan off early. Not all loans include prepayment penalties, so make sure to read the fine print of your loan agreement.
- Weigh other financial goals. Funneling all your extra cash to pay down a loan early means you might have to sacrifice building an emergency fund, saving for retirement or meeting other financial goals. Take time to weigh all your options before committing to an early debt payoff plan.
- Adjust your monthly budget. Take time to review your budget before you make your final loan payment. You’ll get the biggest benefit from paying off a loan early if you have a plan for how you’ll use the extra money you’ll have each month. If you don’t need it for expenses, consider setting up automatic transfers to a savings account for the amount of your loan payment. That way, those freed-up funds can help you work toward another financial goal.
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