For most people, avoiding debt is not an option. Managing debt is. How you make your payments and control your debt affects your credit score, the rating used by lenders when you apply for a mortgage, a car loan or any other installment purchase where you pay by the month. Having some installment debt can actually be better for your rating than having none at all.
Keep Loan Payments Current
A credit score is calculated on five factors and the most common rating is MyFICO, a system of the Fair Isaacs Corp. used by all major credit bureaus and most lenders. The amount you owe and payment history are about 65 percent of the total score. Basically, that means that having installment loans with current payments will not hurt your score. It may even help it by demonstrating you are a good risk.
Payoff Is History
Paying off a loan in a quarter of the time will reduce your amount owed, but it will be listed as a closed account and become part of your credit history. That's only about 15 percent of your FICO score, so even if the loan you pay off is substantial, it may not have much impact on your credit score. Your payment history tracks late payments and delinquencies, not early payments.
Pay Credit Cards, Not Loans
Your credit score will benefit more from paying off or paying down credit card debt rather than installment loan debt. Experian, one of the credit bureaus, advises, "Open and active accounts are scored more highly than closed accounts because they demonstrate that you are managing credit" and notes that credit card payments offer "greater insight into how the individual will manage other accounts."
Keep a Loan Open
Keeping a loan open for 12 to 24 months, with all payments on time, may benefit your credit score more than paying it off in a quarter of the time, especially if you have no long credit history. In fact, getting a loan and keeping payments current is the best way to establish credit. Many young people will have no history except perhaps for student loans, and need to build a credit score to buy a house or new car.
- Bankrate.com: If I Pay Off Loan, How's My Credit Score?
- My FICO: What’s in Your FICO® Score
- Experian: Credit Advice
- Federal Reserve Bank of San Francisco: Consumer Information
- Cars Direct: Pay Off Car Loan Early
- Debt Help: Your Guide to Revolving Credit and Installment Credit
- Smart Credit: Will Paying Off My Installment Loan Early Increase my Credit Score?