Will Paying Off A Personal Loan Early Improve My Credit Score?

Updated: March 22, 2024 Author:

Quick answer: While repaying your personal loan early can help you to get ahead of schedule and save a few extra pounds in interest, it can have an unforeseen impact on your credit.

    What is a Personal Loan?

    A personal loan is a lump sum of money borrowed from a lender, which you pay back in regular instalments over an agreed period of time. Repayments can be fixed or variable, depending on your agreement with the lender. Unlike a mortgage, personal loans are not fixed to an asset, but there are sometimes conditions on what you can use the money for.

    Personal loans can be a great way to finance your goals. They’re relatively flexible and easy to obtain. However, repayments are usually scheduled over a number of years, and they often come with high interest rates.

    So if you have a little spare cash, you may be wondering whether it’s worth paying off your personal loan early.

    How Does A Personal Loan Affect My Credit?

    Your credit score is a numerical representation of the likelihood you will repay a loan. Factors like your payment history, credit utilisation, credit diversity, and recent credit inquiries all go into the calculation of your credit score. Credit scores are usually updated once a month, and they play a significant role in the lender’s decision to lend to you, and under what conditions.

    Paying off a personal loan late can have a predictably negative impact on your credit score, which can make it more difficult to get loans with low interest rates or to take out further credit. 

    Does this mean that paying off a personal loan early can improve your credit?

    The short answer: unfortunately, no – paying off your personal loan early does not help your credit, at least in the short-term.

    In fact, paying off your personal loan early can even temporarily lower your credit score.

    Why does this happen?

    When calculating your credit score, credit accounts that are open are weighted more heavily than credit accounts that are closed. By paying off your personal loan, you are ending the credit relationship and closing your account. As you now have fewer open accounts and less diversity across your credit accounts, your credit score may take a temporary hit. The impact is usually small, but can make the difference between getting approved or rejected for another credit agreement.

    Is It Ever Worth It To Pay Off My Personal Loan Early?

    There may be some scenarios in which paying off your credit score early is worth the impact.

    Any reduction in your credit score when you pay off your personal loan is likely small and temporary, so you may decide it’s worth taking the hit to save on interest and reduce your current debt.

    If you’re not looking to take out a new loan anytime soon, the change to your credit score may not impact you significantly. However, if there’s any chance you may need a loan in unforeseen circumstances—for example, if you don’t have much cash saved up for emergencies—it may be important to keep the option open.

    What to Consider Before Repaying Your Personal Loan Early

    If you’re thinking about repaying your personal loan early, there are a few things to take into consideration.

    1. Prepayment Penalties

    It’s important to be aware of any prepayment penalties built into your agreement with the lender.

    A prepayment penalty is an additional fee which lenders may charge if you pay off your loan early. This is meant to incentivise you to pay off your loan over a longer period of time, and can make it more expensive than you expect to pay off your loan before the agreed end.

    1. Upcoming Plans to Borrow

    If you’re planning to take out another loan in the near future, like a mortgage, your score should be as good as it can be to get the best possible offers from lenders.

    However, another factor you should consider is your debt-to-income ratio. Your debt-to-income ratio does not impact your credit score, but lenders will also use this figure – a calculation of how much you borrow compared to how much you earn – to decide whether or not to lend to you. Paying off your personal loan may lower your debt-to-income ratio, which can be a positive mark against your lending applications.

    If you’re not sure what impact paying off your personal loan early could have on your credit applications, you could speak to a financial advisor.

    1. Other Credit

    If you have other forms of credit open, you may want to consider which payment would be the most beneficial for your credit. For example, if you have credit card debt, this is likely to carry a higher interest rate and have a greater impact on your credit score. Therefore, any spare cash that you might be able to use to pay off your personal loan could be better used to pay off your other debt.

    If you’re not sure which credit would be best to pay off first, consider this carefully – again, you may wish to consult a financial advisor.

    Conclusions

    To summarise: no, paying off your personal loan early isn’t guaranteed to be good for your credit score – but there are some situations where it may still be beneficial.

    It’s important to consider all the factors at play when deciding whether or not to pay off your personal loan early, including the terms of your loan agreement and any other credit, future plans, or safety nets you might have.

    Any negative impact on your credit after paying off your personal loan early is likely to be small and short term, so don’t panic if you see an unexpected downtick.

    Every situation is unique. A financial advisor can help you to understand your credit and the impact of early personal loan repayments, and can support you to make the right financial decision for you.