Is it Good for Your Credit to Pay a Car Off Early?

If you're looking for ways to improve your credit score, paying off your loans is a good start. Some loans, such as an auto loan, are easier to pay off than other loans, such as a mortgage. However, before you decide to pay off your auto loan, it's important to consider any possible penalties and whether or not you can afford to do so.

How it Can Help Your Credit

Anytime you pay off a loan, you will see your credit score respond positively. Paying off an auto loan means that you have one less loan, which means that your debt-to-income ratio has gone down. Lenders look at your debt-to-income ratio when deciding whether or not to approve you for a loan; a high debt-to-income ratio tells lenders that you're a risk. While your credit will certainly improve if you pay off your auto loan, it's impossible to estimate how much it will improve. If you have other factors bringing down your credit, such as late payments, there will be little improvement.

Prepayment Penalty

Look at your loan agreement. Some lenders impose a prepayment penalty, which means that you're going to pay more if you pay the loan off early. According to All Things Frugal, most prepayment penalties are attached to high interest loans given to people with bad credit. If you have a low interest auto loan, chances are there is no prepayment penalty. Fourteen states allow prepayment penalties, according to All Things Frugal.

Affording a Payoff

Consider your financial situation. You should never dip into your emergency fund to pay off an auto loan, because it's simply not worth it. If you have the extra money sitting around, and it won't hurt you financially if an emergency comes up, then paying off your car may be a good idea.

When to Pay it Off

The reason people finance a car is either to build credit or because they can't purchase the car outright. Your credit worthiness is partially determined by your payment history. If you pay off a loan three months after you take it out, you're not going to see a huge improvement to your credit. Cars Direct suggests waiting 12 to 24 months to pay off a loan so that the payment history will improve your credit rating.

Insurance

You can drop your full coverage auto insurance after paying off your auto loan. Full coverage auto insurance is required by most lenders. However, full coverage insurance tends to cost more than other forms, such as liability-only insurance. Once you pay off the loan you can drop full coverage and choose another type of insurance.