How Closed Auto Loans in Good Standing Boost Credit Scores

Getting a new car is exciting! But before you drive off the lot, it’s important to understand how your auto loan can affect your credit score down the road. The good news? Paying off your car loan responsibly can actually help boost your credit over time.

The Initial Credit Score Drop

When you first apply for an auto loan, the hard inquiry from the lender will likely cause a small, temporary drop in your credit score – usually only a few points. This is normal, as creditors view hard inquiries as a sign of risk since it means you’re asking for more credit [2].

In addition, the new loan itself will initially increase your credit utilization ratio, which can also cause your score to go down slightly. Your utilization ratio is how much credit you’re using compared to how much you have available. Since the new car loan increases your total debt, it bumps up your utilization – and lower utilization is better for your score.

The Power of On-Time Payments

Now here’s the good part – making regular, on-time payments on your auto loan will cause your score to start improving again. On-time payment history has the biggest positive impact on your credit score, accounting for a whopping 35% of your total score [3].

Creditors want to see that you can responsibly manage debt over time. So as you make consistent payments month after month, your score will gradually increase. Many experts recommend waiting at least 6 months before assessing the positive impact of your new loan.

Payment Milestones

You can expect to see a noticeable boost in your credit score at these key payment milestones [5]:

• 6 months of on-time payments
• 12 months of on-time payments
• 24 months of on-time payments

The longer you make reliable payments, the better it is for your score. Setting up autopay through your lender is a great way to ensure you never miss a payment.

Improving Credit Mix

Having an auto loan can also help improve your credit mix, which accounts for 10% of your total score. Credit mix refers to the different types of loans and credit cards you have – including installment loans, revolving credit, and mortgages.

Lenders like to see you’ve successfully managed different types of credit, not just credit cards. An auto loan adds an installment loan to your credit mix, which diversifies your credit profile.

Decreasing Debt

As you pay down your car loan over time, your credit score will also benefit from the decrease in your overall debt load. The credit bureaus like to see that you’re able to pay off debt responsibly.

Plus, making payments reduces your credit utilization ratio since you owe less principal. Lower utilization means a higher score.

How Closing the Loan Affects Your Credit

Once you’ve paid off your car loan entirely, you might see a small drop in your credit score again when the account officially closes. This is normal and temporary.

The reason is that closing any credit account reduces the total amount of credit available to you, which can negatively impact your utilization ratio and credit mix [4].

However, if you have a long history of on-time payments, the hit is usually only a few points before your score starts to recover again. And your improved payment history and decreased debts will still benefit you in the long run.

Strategies to Minimize Score Drop

If you want to avoid even a small, temporary drop, here are some tips:

• Wait to pay off the loan until after you make any major purchases requiring credit checks, like a mortgage.
• Pay off most of the loan, but leave a small balance and keep making minimum payments.
• Only pay off the loan early if you have other established installment loans in good standing.

Talk to your lender if you need guidance on the best payoff strategy for your unique situation.

The Credit Score Benefits Add Up

While paying off an auto loan early may cause a small short-term score drop, the long-term benefits are significant. A strong history of on-time payments, decreasing debts, and diverse credit mix will boost your score over many years.

As long as you make payments responsibly, your auto loan can put you well on your way to excellent credit. Then you’ll reap rewards like lower interest rates and more opportunities in the future. So enjoy the drive in your new car, and know you’re also driving towards better credit!