What to Expect After Paying Off an Installment Loan

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, including: Your credit score could change, and you’ll have extra money each month.

Here’s what can happen — and what you can do — once you pay off your loan.

Your credit score may dip

You read that right: Paying off a debt can cause your credit score to drop.

Your credit utilization — the portion of total available credit that you’re using — is a major factor in your FICO score calculation. Once you close the loan account, your available credit will drop and your utilization could spike.

The age of accounts and your credit mix also affect your credit score. Paying off an installment loan that’s several years old or the only installment credit you have (as opposed to credit cards’ revolving credit) can also affect your score.

Once the loan account is closed, continue making on-time payments toward other loans and credit cards to strengthen your credit.

Your debt-to-income ratio will drop

Your debt-to-income ratio is the percent 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 to determine whether you can afford the monthly payment on a new personal loan, mortgage or auto loan. The lower the number, the better.

Put your extra money to work

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.

• Contribute toward your 401(k). If your employer offers a 401(k) match, chip in enough money to get its full contribution.

• Pay off other high-interest debt. Putting extra money toward credit card or high-interest loan payments helps whittle down that debt faster.

• Save more for retirement. Most financial experts recommend putting 10% to 15% of your pretax income in a retirement account like a 401(k) or IRA.

• Save for your next big goal. That could be a down payment on a house, your kids’ college education or a dream vacation.

» MORE: New financial goals? Learn how to reach them

Look for lower rates

On-time payments toward credit cards and installment loans help build your credit score, so after paying off a loan you may qualify for lower annual percentage rates on new credit.

Compare unsecured borrowing options

Savings are usually the cheapest way to pay for a big vacation, wedding or home improvement project. But if you need to finance those projects, consider a credit card or personal loan.

• Personal loans have APRs between 5% and 36%. Lower APRs are reserved for borrowers with good or excellent credit. Borrowers can use these loans to finance large, one-time purchases or consolidate other high-interest debts. Pre-qualify to check your potential personal loan rate without hurting your credit score.

• Credit cards tend to have APRs between 13% and 25% and are best for small, regular purchases. Consumers with good or excellent credit may qualify for a rewards or 0% interest credit card.

Refinance

With better credit and a lower debt-to-income ratio, you may be able to refinance your other loans to get a lower interest rate.