Car Loans and Credit Scores
Car loans are classified as installment loans on your credit report, since they are repaid over a set period of time with regular payments. Paying an installment loan on time positively impacts your credit score, which is why taking out a loan has a more beneficial effect than paying for a car in cash. It’s not the amount of the purchase that matters, but the prudent management of credit in paying the purchase off.
This treatment of car loans contrasts with how revolving accounts like credit cards accounts are treated. For revolving accounts, it helps your score to have a lower credit utilization ratio, which compares your balance to your available credit. For credit scoring purposes, therefore, it helps more to use extra money to pare down revolving accounts than it does to settle your car loan.
No Early Benefits
While it may seem like a great idea to pay off a car loan early, that won’t have a positive effect on your credit score -- and may actually have the opposite effect. Paying off the loan makes it a closed account, which doesn’t help as much as an open account that’s always paid on time. It also increases your utilization ratio. For example, say you have $5,000 remaining on a $25,000 auto loan, and $10,000 in credit card debt with an available credit limit of $15,000. Your available credit is $40,000 and your debt is $15,000, for a total utilization ratio of 37.5 percent. Once the car is paid off and the account is closed, it drops off your utilization ratio calculations. That leaves you with just the credit card debt -- and a less healthy 66.7 percent ratio.
The calculus of paying off a car loan differs if you have a history of late payments. In that scenario, the account isn’t helping your credit score, and paying it off to make it a closed account would be beneficial. The sooner an account with delinquencies is closed, the sooner it falls off your credit report and future lenders will stop seeing it. Accounts fall off after seven years of being closed, and delinquencies have less impact the older they are.
While being behind on loans is bad for your credit, defaulting on a loan is far worse. Not only is it a negative mark on your credit report, it also can lead to additional negative actions. Your creditor can take you to court in your state asking for a judgment to repay your balance. It also can repossess the vehicle, meaning you may be on the hook for money owed on a car that’s no longer yours. Paying off your car loan early ensures that the loan will never go into default.