There are many different kinds of credit. One of the most common is the auto loan.
Now, as hot as we all are to pay off our long-term debts and own something free and clear, there are a couple of things to know before racing to get that statement down to zero.
Credit score simulator
What happens if…
I pay off this much debt:Get your score!
Your new score:
To determine if paying off your car loan off will help your credit, you’ll need to understand several things and construct scenarios to see how that action may play out.
What goes into your credit scores
These are the five most important elements in your scores:
- Payment history is highly influential. It’s your record of on-time payments and any black marks, such as late payments, accounts sent to collection or judgments against you.
- Credit utilization is the other highly influential element. It reflects how much of your available credit you’re using.
- Age of credit history, or how long you’ve been borrowing money, is moderately influential.
- Applications, or whether you’ve applied for a lot of credit recently, is somewhat influential.
- How many and what kinds of credit accounts you have is somewhat influential. Do you have credit cards, installment debt — including mortgage and car loans — or some of each?
The relative importance of each category depends on you.
If you have an auto loan that you’ve been diligent about paying, you’ve benefited from the fact that payment history weighs heavily in your scores. By paying it down, you’re also decreasing your credit utilization — unless you’re running up balances on other forms of credit — and that can help your score. And chances are it’s at least a three-year loan, if not five years, so you also have length of credit history going for you.
Types of credit
But take a look at the final element going into your credit score: types of credit used. On the positive side, a car loan diversifies the types of credit you have, assuming you have things like credit cards or perhaps a mortgage. On the negative side, if you pay it off, you may eliminate the installment loan as a type of credit used.
Credit bureaus like to see these installment accounts, because they have fixed payments each month and often are secured by an asset. You don’t have to pay the account in full each month, but you must pay the required payment amount. In this case, the interest charges are built in at the start of the loan and usually are amortized, or paid off, over the life of the loan. Thus, it’s a different kind of credit than a credit card.
Your ability to pay installment accounts, in addition to others, shows credit bureaus that you’re responsible and diligent enough to plan your finances around all these different types of credit.
The biggest factor
Weighing against all this, however, is a large factor that requires you to look more holistically at your credit lifestyle.
Every day you carry a balance is a day you’re paying interest on a loan. That’s money you’re just giving to your creditor. You could spend that money more effectively, or save it.
A general rule of thumb is that if you can pay off a debt of any kind in full, do so — except for a mortgage. Home loans usually carry relatively low interest rates and bring tax benefits.
Adding it all up
The minor boost you get in your credit history by maintaining an installment account isn’t a reason to keep the account open, in general. You’re likely to benefit more by paying the loan off in full and owning that car outright.