Paying off an installment loan early reduces your amount of debt and frees up funds to be used elsewhere. On the other hand, regular repayment of installment debt can boost your credit score and show you're continuing to handle your credit obligations. The best repayment strategy for you depends on your own financial situation, and whether you'd benefit more by the reduced obligations or the credit score boost.
How Installment Loans Help
Responsible use of installment accounts can boost your credit score several ways. Equifax, one of the three major credit bureaus, notes that approximately 15 percent of your score is based on the number and type of credit used, and 35 percent is based on your payment history. In addition, open accounts are more beneficial in your credit score calculations than closed accounts, so keeping an account open maximizes its impact. The lack of recent activity regarding installment accounts can hurt your score.
In addition, paying off an installment loan early could lower your credit score by increasing your utilization rate. This measures the amount of credit you're using as compared to your total available credit line. If you've already paid off a good portion of the loan balance, paying the rest in a lump sum can be counterproductive to your credit rating.
For example, say you have a $1,000 balance remaining on an installment loan that originally was for $10,000. You also have $3,000 of credit card debt, with a $5,000 credit limit. That gives you $4,000 in debt to $15,000 available credit, for a utilization rate of 26.67 percent. Since that's below 30 percent, it's generally considered an excellent ratio. If you pay off the loan and close the account, the credit card balance is your only debt considered. Now, your utilization rate is 60 percent -- the $3,000 in remaining debt divided by the $5,000 limit -- and your score will drop accordingly.
The Best Way to Pay
To maximize the impact on your credit score, stretch out your installment loan payments as long as your agreement allows. Pay each installment on time to avoid late charges -- and to avoid the derogatory credit report entries that would negate the positive effect of your previous activity. Set up automatic payments from your bank account to go out the same day each month, or set a reminder on your calendar so you don't forget to send in the check.
Exceptions to the Rule
Unless you have a loan with 0 percent interest, you're paying for the privilege of borrowing money. The higher the interest rate on your installment loan, the more costly the payments are. An installment loan at above-market rates should be paid off, and perhaps replaced by one with more reasonable terms. If you have a number of installment loans, getting rid of the higher-priced ones is particularly attractive.
In addition, paying off the loan early in specific circumstances can help meet your financial goals. A mortgage lender, for example, may express more concern about your total debt than your credit score, in which case paying off an installment loan early is beneficial. It's also beneficial if you're having trouble making regular payments but receive a windfall, such as an inheritance check or tax refund, that allows you to pay it off early.