Dave Ramsey tells people that FICO® Scores aren’t credit scores; they’re “I love debt” scores. Case in point: last week, I paid off my auto loan. This week, my FICO® score dropped 60 points. 60! There have been no other changes to my credit report.
Needless to say, I’m pretty flabbergasted…and pissed off…that my score dropped that much for doing something good… paying off debt!
I didn’t really think about the credit score consequences of paying this debt because I’m not worried about my credit score; I’m worried about becoming debt-free. And although I could have predicted that my score would’ve taken a small dip for paying off a loan, I didn’t expect my credit to be so harshly punished for it.
So why did it happen? Why would your FICO® Score take a tumble for paying off your auto loan? Can it be avoided? And lastly, if it can’t, is it still worth it to pay off your auto loan early?
Why paying off your auto loan early can actually hurt your credit
A lotta folks see their credit score as a sort of “financial responsibility report card.”
It’s a reflection of your fiscal responsibility, sure, but there’s much more to it.
To explain why your credit score drops for doing something “good” like paying off a loan, we first need to recap how credit really works.
A quick recap of how credit works
Imagine you’re an auto lender and somebody wants to borrow $20,000 to buy a truck.
Before forking over 20k, you’ll probably have questions.
How trustworthy is this person? Have they taken out loans before and paid them back? Do they currently have other debt that they’re struggling to pay off? What would their past lenders say about them?
Knowing these things will help you determine whether you want to loan to them or not, and if so, how much interest to charge them to compensate for your risk.
To educate your decision you can look at their past loan history. Lenders report their loan data to credit bureaus, who compile it for other lenders to see.
But do you really want to spend 30 minutes browsing a stranger’s loan history? Probably not.
To spare lenders from this misery, the credit bureaus came up with the idea of a credit score: a three-digit number summarizing someone’s credit history.
The two most common types of credit scores are the FICO® Score and VantageScore®. They’re a bit like the SAT and ACT scores of the credit world. 90% of top lenders prefer the FICO® Score, so that’s my focus here (I’ll be using the terms FICO® Score and credit score interchangeably from here on out).
Your FICO® Score is automatically compiled using the following criteria:
- 35% – Payments history – Have you paid off your past credit accounts in time?
- 30% – Amounts owed – What percentage of your available credit are you using up?
- 15% – Length of credit history – How old is your credit history and the average age of accounts?
- 10% – Credit mix – Do you take out a healthy variety of loan types (auto, home, etc.)?
- 10% – New credit – Have you recently taken out a lot of loans in a short span of time?
You can see that your FICO® Score is a little more complicated than just “how trustworthy are you” – it demonstrates dependability, sure, but also experience and knowledge.
A high FICO® Score says “I’m good at debt.”
It’s important to remember that your credit score is calculated by a computer, not subjectively analyzed by a lender. That’s why seemingly “good” actions can actually hurt your credit. Let’s dig into that odd phenomenon.
Why paying off loans early can hurt your credit score
To start, let’s cover why taking out an auto loan is good for your credit by looking at the five pillars of a FICO® Score. Keep in mind that I don’t work for FICO so this is only speculation, driven by experience and basic logic:
- 35% – Payments history – If you haven’t missed a car payment, you’ve built up credit here.
- 30% – Amounts owed – If your auto loan hasn’t hyperextended your credit, your loan helped build credit in this category, too.
- 15% – Length of credit history – If you’re paying off your auto loan now, you probably took it out years ago, which means you have years at least of credit history.
- 10% – Credit mix – If this was your only auto loan, you almost certainly improved your credit mix.
- 10% – New credit – You lose points here if you opened too many lines of credit in a short span of time, so it probably wasn’t solely impacted by the status of your auto loan.
Now, when you pay off your auto loan, you’re ending one of your lines of credit. In terms of how this impacts your FICO® Score, it’s a bit like removing a good test score from your end-of-semester average. Biologically speaking, it’s like removing a source of nutrition from healthy credit.
Again, FICO’s exact math is a trade secret, but we can speculate with reasonable confidence by looking at all five elements. How would ending a line of credit prematurely hurt you?
- 35% – Payments history – An early prepayment removes the chance for future on-time payments, potentially hurting you in this category.
- 30% – Amounts owed – Paying off your loan early could zero out your amounts owed, which could actually hurt your score.
- 15% – Length of credit history – Paying off your loan early may hurt the average life of the loans you’ve taken out, losing points in this category.
- 10% – Credit mix – Without an auto loan your credit mix is reduced, potentially costing you points in this category.
- 10% – New credit – Once again, this aspect of your FICO® Score probably didn’t factor in here.
In short, paying off an auto loan early can hurt your FICO® Score because you’re potentially:
- Missing out on future on-time payments.
- Reducing your Amounts Owed.
- Reducing the average length of all of your loans.
- Reducing your credit mix.
To draw another loose analogy from academia, paying off your auto loan early is a bit like losing points on your participation grade because you left class early.
Why paying off loans on time still hurts your credit (but not as much)
You might have noticed that bullets two, four, and sometimes even three above still apply even if you pay off your loan on time.
They do, and that’s why paying off a loan at all can still hurt your credit.
Again, your FICO® Score (aka credit score) isn’t a measure of your wealth or financial responsibility; it’s a measure of the length and variety of loans you have out and your ability to pay them back.
That’s why when it comes to building credit, it’s better to make regular on-time payments than to have no line of credit at all.
That also explains why if I had just kept making payments until the end of my loan term, my score might’ve dipped 3 points, not 60. That’s because I would’ve made many more on-time payments and extended the life of the loan.
Can you pay off your auto loan early without penalty?
It totally depends on your lender, since your FICO® Score delta depends on what they report to the credit bureaus.
To determine your options for early payment, unbury your loan agreement from your email and check inside for a section called the prepayment clause.
It’s important to read this section carefully because, in reality, there are two penalties for paying off your loan early:
- A ding to your credit score and,
- A prepayment penalty with your lender.
It’s important that you understand the latter, because if your lender charges high fees for prepayment, it may nullify any financial incentive to pay off your loan early.
Why lenders charge prepayment fees, and how to avoid them
It seems a little unfair that your lender would penalize you for simply giving their money back early. I mean, shouldn’t they be thanking you?
Not quite, because prepayments are actually a bit of a headache for lenders.
Let’s look at a prepayment situation from their perspective. Remember earlier when you lent that guy $20,000 to buy a truck? You only took on the risk because he agreed to pay $5,000 in interest.
But imagine if after paying $2,000 in interest, he just cut you a check for the rest of the principal and walked off.
I mean, it’s great that he paid you back, but… where’s the extra $3,000 you agreed on?
Interest is income to lenders. It’s hard to balance the books if everyone they lend to withholds the right to suddenly not pay them interest anymore. That’s why “prepayment penalties” are really “you didn’t pay us all the interest you agreed to” penalties.
To recoup their sudden missing interest, lenders typically charge one of three types of prepayment penalties:
- All of your remaining interest.
- A percentage of your remaining interest.
- A flat fee.
Since the difference between these three can amount to thousands of dollars, it (literally) pays to carefully inspect the prepayment clause on all future loan offers.
As for how to avoid these fees, I have good news and bad news.
The bad news is whatever terms you see in your prepayment clause you’re pretty much locked into. Your only option to eliminate or lessen your lender’s prepayment fees is to call them up and ask (hey, it works sometimes).
Monevo is like the Kayak.com of personal loans. It’s not a lender itself, but it shows you offers from dozens of lenders at once and takes an origination fee from the lender, not you. You can take out a loan for almost any reason, from an auto purchase to an auto repair, cosmetic procedures to education, and best of all, you can browse offers in seconds with only a soft credit pull.
LendingClub is friendlier to applicants with imperfect credit, allows for loans as little as $1,000, and of course, charges no prepayment penalties. It’s also a nice alternative to borrowing from a bank; LendingClub Bank is a peer-to-peer lender, meaning your interest payments benefit everyday folks like you and me, not some institution.
How to avoid prepayment penalties to your credit
The same answer, actually; talk to your lender. They may have options and ideas for how to rearrange your loan terms to avoid hurting your credit.
A common resolution is to make a partial lump payment against your principal and interest. Paying your lender a few thousand bucks will reduce the amount you owe each month and help you save on interest.
To preserve your credit, however, your lender may recommend that you keep your term length where it is. Even if you’re only making $50 monthly payments, keeping the number of payments the same is a good way to avoid hurting your credit score since it won’t be as impactful to your credit score as suddenly ceasing payments altogether.
Still, your lender will know best. Simply ask, and they can help.
Here’s why you should (and shouldn’t) pay off your auto loan early
If you have outstanding debt on an auto loan and cash to pay it, it may be tempting to cut your lender a check and drive off into the sunset debt-free.
However, this logical choice may not be the best for your credit or bank account. Here are some pros and cons to consider.
Pros to paying off your auto loan early
- It can save you money. Depending on your lender’s prepayment penalties, paying off your auto loan early could save you hundreds, if not thousands in interest.
- It may actually improve your credit. Yep, this whole article is about how paying off loans early can hurt your credit, but sometimes the opposite is true. This is simply because paying off your loan early eliminates the possibility of missed payments.
- It feels good. Living debt-free (or close to it) can be good for your mental health. Therefore, the penalties to your credit and bank account might be worth the peace of mind.
Cons to paying off your auto loan early
- It can hurt your credit. Paying off an auto loan early eliminates a (presumably) healthy line of open credit, potentially hurting your credit score.
- You might be subject to penalties. Check your loan agreement; if you try to repay your principal your lender may charge you all or some of your unpaid interest, or at least a flat fee. If your fees are high, a prepayment may not make fiscal sense.
- It might be better to hold onto that money. If you have to dig into a savings or emergency fund to pay off your auto loan, you might want to reconsider staying liquid in case you need that money. Also, if the difference between paying off and keeping your loan is under $100, you might keep your loan and invest your payout money instead.
It can be hard to predict exactly how a prepayment will impact your credit (it may even improve it). So instead, educate your decision by carefully reviewing your prepayment clause and doing the math to see precisely how much money you’d save by prepaying (if any).
Admittedly, I was quite surprised when this happened. Why would paying my lender back hurt my credit score?
It doesn’t make much sense until you look at the individual factors that make up your FICO® Score. Paying off a loan early equates to ending a healthy line of credit; on-time payments, a credit mix, and a longer credit history are all things you miss out on.
That said, it may still benefit you to pay off your loan early if you have the cash. If your lender’s prepayment penalties are low and you have plenty of time to rebuild your credit before your next big loan, it might make sense.
Fortunately, I have no plans to use credit anytime soon, but I do hope that my other loans and on-time payments help my score come back up fairly quickly.
Has this ever happened to you? Have you ever had to decide between paying off a loan or not, and how did it go? Let me know in the comments!