Car Loans and Credit Scores: How the Two Interact
Will Paying Off Car Improve Credit?
A car payment can be a substantial financial stressor in your life, especially if you have other types of debt at the same time. Between student loans, credit card payments, and other bills, such as your auto insurance, it's easy to start to feel the stress. For this reason alone, many people aim to pay off their debts to free up money for their savings and other life goals.
However, while paying off your debt is an admirable goal, it can lead to some concerns when it comes to your credit score. Since your credit score depends on the types of debt you have and your payment history, many people may be surprised to see a sudden change in their numbers after paying off a substantial debt like their car. So, will paying off a vehicle improve your credit?
The Impact of Paying Off Debt on Your Credit Score
It can be tricky to calculate your credit score, simply because of how many different factors contribute to it. As mentioned, the more on-time payments you make, the better your score will be, so it would seem like paying off a loan would show that you have excellent money management skills. However, because it matters what types of accounts that you have, it's not that simple.
When it comes to debt, there are two significant kinds: revolving credit and installment loans. Revolving credit refers to ongoing bills, like your credit card, where even if you pay your account down to zero, it remains open, allowing you to gain more payments in the future, such as when you use your credit card on a new purchase.
Installment loans are debts that you pay off in pieces, usually with monthly payments. Many types of debt, such as student loans, mortgages, and, yes, car payments, fall into this category. With an installment loan, once you pay down the account to zero, it will close up and won't reopen for any additional payments.
When you have both revolving credit and installment loans in your history, it will help to boost your credit score because it shows that you can handle both types of debt—so long as you're making your payments on time. Usually, paying off an installment loan doesn't improve your score, often having a neutral effect, leaving your numbers as is. In some cases, though, it can decrease your credit score.
Understanding Credit Mixing
The variety of types of loans you have is also known as your credit mix, which does impact a fraction of your credit score, depending on the calculation model used. Part of that does involve revolving credit and installment loans, but it can also amount to the number of applicable accounts you have open.
Credit mixing can also have a more significant impact on your score if you don't have a long enough payment history to affect your numbers. However, intentionally seeking out new types of loans to help your score can easily have negative results in the long run.
Car Loans and Credit Scores
Since a car loan is an installment loan, it can positively impact your credit score so long as you are making your payments on time every month. If you pay the allotted amount every month until the end of your loan term, your credit score should stay in good shape. It's when you've entirely paid off your car loan that you may see other effects.
For the most part, finishing paying an installment loan won't have much of an impact on your credit score. Usually, your number will remain the same. However, there are times when paying off your car loan, whether it's on time or early, can lead to a temporary drop in your score.
Usually, when this decrease happens, it's because your car loan was your only installment loan left on your credit account. By paying it off, you'll no longer have a mix of credit accounts, and possibly only revolving credit or no credit left, which can negatively impact credit scores. Thankfully, though, most people only see a minor drop in points when this happens, and it's usually only temporary.
Even if you have fully paid off your debts, though, that doesn't mean you've lost anyway to maintain your credit. If you stay up to date on payments for both your installment loans and revolving credit, they can continue to have a positive impact on your credit score for up to ten years past your final payment date. However, you want to be cautious, as late payments can pull your score down for up to seven years.
Timing Your Payoff Right
Since credit score calculations are complicated, there's no guaranteed way to know whether you'll see no change or a decrease whenever you pay off your car loan. However, you shouldn't decide to stay in debt just for the sake of boosting your credit score. What you should do is pay attention to when you choose to pay off a car loan, especially if you're doing so early.
Remember that your credit score can impact many things, like your ability to receive approval for a loan or getting a better deal on financing, especially when it comes to your interest rates. The best range for your credit score is usually in the 700s and dipping down into the 600s can make a difference when it comes to financing, potentially increasing new car prices.
If your credit score is close to a tipping point number, it can help to avoid anything that could potentially drop your score when applying for a new loan. In these cases, if you're paying off your car early, you may want to wait until you've completed the approval process for your new loan so that you don't have any unwanted changes in your credit score.
Alternatively, you may choose to wait to apply for your new loan after you've paid off your car to give your credit score time to even out in the aftermath. This option may be necessary if the final payoff date for your vehicle is approaching. Since missing payments can drastically impact your credit score, you want to avoid upsetting your score, both for the present and how it will affect you in the future.
Whichever option you choose to go with, the key is to not pay off your car loan at the same time as applying for a new one or anything else that requires you to have a high credit score, just in case you see a temporary drop.
Refinancing Car Loans
With your auto loan, refinancing may be necessary for various reasons. If you're having trouble paying off your current payments, you may choose to refinance to make your bills more manageable. Other common reasons for refinancing include getting a lower interest rate, changing the lending period, or getting better loan terms.
Since refinancing your car is the equivalent of closing one loan to open another, it will also impact your credit score. Just like with paying off your vehicle, you'll likely see a temporary drop in your score. As you continue to make on-time payments, however, your number should increase back to where it was before. This impact will be the same whether you’re refinancing a GMC vehicle or Ram trucks.
If you're considering refinancing your auto loan, be sure to:
- Check your credit report in advance
- Only apply for auto loans and try to keep them in the same forty-five-day time period
- Research loans beforehand
Though you'll still see some changes in your credit score, you can limit their impact and better understand how your financing plays into your broader credit mix as one of the accounts that make up your credit report.