You’ve finally paid off that personal loan you took out a few years ago. Congratulations! Not only are you now debt-free, but you’re also probably wondering how this will affect your credit score.
Unfortunately, there’s no one-size-fits-all answer to this question. The impact of paying off a personal loan on your credit score will depend on a variety of factors, including your payment history leading up to the loan payoff, the amount of outstanding debt you have, and your credit utilization ratio.
In general, in the long term, paying off a personal loan should have a positive impact on your credit score. If you’ve been consistently making on-time payments and keeping your debt levels low, paying off a personal loan can give your score an additional boost. On the other hand, if you’ve been struggling to make payments or carrying a high balance relative to your credit limit, paying off a personal loan may not have much of an effect on your score.
In the short term, paying off a loan will actually have a negative impact on your credit score. Why? As your total credit limit decreases (when the personal loan is closed), it has a short term negative impact. Over time though, decreasing debt will have a positive impact.
What has an impact on your credit score?
How Does Your Payment History Affect Your Credit Score?
One of the most important factors in determining your credit score is your payment history. This is a record of whether you’ve made all of your payments on time, and it accounts for about 35% of your FICO® Score☉ . Therefore, if you have a good payment history leading up to the payoff of your personal loan, this will likely have a positive impact on your score.
If, however, you’ve missed any payments or made late payments on your personal loan (or any other debts for that matter), this will likely harm your score. In fact, even one 30-day late payment can cause significant damage to your credit scores—so if you’re behind on any payments, it’s important to get caught up as soon as possible before you try to pay off your loan.
How Does the Amount of Debt & Credit Utilization Ratio Affect Your Credit Score?
Another factor that will affect the impact of paying off a personal loan on your credit score is the amount of outstanding debt you have relative to the amount of available credit you have—known as your “credit utilization ratio.” This makes up about 30% of your FICO® Score and is one reason why it’s generally advisable to keep balances low relative to credit limits (i.e., maintain a low credit utilization ratio).
If paying off a personal loan brings down your overall debt level and improves your credit utilization ratio—especially if it lowers it below 30%—this could help improve your scores over time. On the other hand, if paying off the loan doesn’t change these ratios much (or makes them worse), it could hurt scores in the short term by signaling that you’re maxing out available lines of credit—even if those lines are now zeroed out.
How Does the Type of Loan Affect Your Credit Score?
The type of loan you had also plays a role in how paying it off affects your credit score. For example, if you had a secured loan—one that’s backed by collateral like a car or home—then paying it off will likely have little effect on your score since lenders already consider that type of debt to be low-risk. On the other hand, if you had an unsecured personal loan—one that’s not backed by collateral—then paying it off will likely have a positive effect on your score since unsecured loans are considered to be higher-risk by lenders.
How Do Other Factors Affect Your Credit Score?
In addition to payment history and credit utilization ratio, there are several other factors that make up your credit scores—including the types of accounts you have (10%), length of credit history (15%), new credit inquiries (10%), and more. So even if paying off a personal loan doesn’t have much of an immediate impact on these factors, maintaining good financial habits in these areas can help improve scores over time.
While there’s no definitive answer to how paying off a personal loan affects one’s credit score—it depends on too many individual factors—in general, it should have a positive impact if you maintain good financial habits in other areas relating to debt and credit use. If not, it may not have much of an effect at all or could potentially lower scores due to changes in overall debt levels or perceived responsible use of available lines of credit. Therefore, if you’re considering taking out a personal loan or are already repaying one, be sure to monitor these other areas affecting your score so that you can mitigate any potential negative impacts down the road.