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Dear credible money coach,
I took out a private bank loan of $ 20,000 for a year. If I pay it back early in the third or fourth month, will it affect my creditworthiness for or against? – Mark D.
Hello Markus and thank you for your question. First of all, I would like to commend you for managing your finances so well that you are able to prepay off a significant amount of the loan.
If you pay off a loan before the term expires, you can save the interest costs that you would have paid if you had waited the entire term before repaying the loan. And who doesn’t want to save wherever possible?
But like almost any financial decision you can make, early repayment of a personal loan has its advantages and disadvantages. To understand how prepaying a loan can affect your credit score, let’s first look at how credit scores work.
Factors that determine creditworthiness
Credit rating agencies use proprietary models to process consumer credit report data and generate credit ratings. Although your creditworthiness can vary depending on the agency that creates it, credit rating models generally take into account the same basic factors (in this order):
- Your payment history
- Total amounts you owe
- How long you’ve used your funds (your credit history)
- The mix of loan types that you have
- How many new loan applications or accounts you have
Lenders and credit bureaus view these factors as indicators of how well you have managed credit in the past and how you are likely to be managing new credit accounts. A long history of on-time loan payments, lower total debt, and a good mix of loan types can all contribute to a higher credit score.
How repaying a loan can affect creditworthiness
It is possible (but not certain) that your creditworthiness will drop slightly immediately after you repay a loan. That’s because paying back a debt affects some of the creditworthiness factors that we just discussed.
When you pay off a loan – whether you do it on time or ahead of time, as you consider doing – you are reducing the number of loan types you use. Credit scoring models generally prefer a mix like credit cards, installment loans, mortgages, etc. A mix may suggest that you are good at managing different types of credit, rather than just one type.
Paying back the loan also reduces your total available loan amount, which in turn affects your loan utilization rate – the comparison between the loan you used and the total available loan.
If your loan early repayment goal is to give yourself breathing space to take on a bigger, more significant debt like a mortgage, you may not want your credit worth going down now. It may make more sense to use your money to pay off any credit card or student loan debt you may have.
Why it can still be a good idea to pay off your loan early
Now you might be thinking, “Bummer! Think I’ll keep my loan.” But despite the possible short-term impact on your credit score, there are some very good reasons to pay off your loan early.
I’ve already mentioned one – interest savings. If you pay off your loan after just three months, you will save nine months in interest. With a $ 20,000 loan, this amount can be significant depending on your interest rate.
Then there’s the benefit of eliminating the monthly payment, which is likely to be over $ 1,000. Imagine keeping that amount of money in your pocket for the rest of the year. What could you do with it Pay off other higher-interest debt? Build an emergency fund? Are you increasing your retirement savings?
Finally, there is the psychological push to pay off a debt. It’s a satisfying feeling. If avoiding a temporary decline in your credit score isn’t a priority right now and you don’t need the money for anything else, pay off your loan early.
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About the author: Laura Adams is a personal finance and small business expert, award-winning writer, and host of Money girl, a premier weekly audio podcast and blog. She is often quoted in the national media and millions of readers and listeners benefit from her practical financial advice. Laura’s mission is to help consumers live richer lives through her speeches, speaker and advocacy. She has an MBA from the University of Florida and lives in Vero Beach, Florida. Follow her up LauraDAdams.com, Instagram, Facebook, Twitter, and LinkedIn.