A reader wants to know if paying off an interest-free loan will help. The answer might surprise her.
3 minute read
This might sound like a weird question, but should I pay off my car loan? The balance is just under $5,000, and it’s a zero-percent interest rate. I have enough saved up, and I have no other debt in my life except my mortgage. I even paid off my credit cards last year! Will paying off this auto loan help my credit score? Will it get me a lower interest rate if I want to refinance my home?
– Kayla in New York
Howard Dvorkin CPA responds…
If you think your question is weird, Kayla, you’re going to think my answer is even weirder. No, you most definitely should not pay off your interest-free auto loan.
That might sound odd coming from a CPA and personal finance expert, but the numbers don’t lie. They can, however, seem illogical.
Paying off interest-free loans can actually be bad for your credit
Would you believe me if I told you that paying off this loan could make your credit score go down? Here’s why in five simple sentences:
Your credit score is determined by five factors. Two of them matter most here: “Payment history” is 30 percent of your score, and “average age of credit” is 15 percent.
The longer you make timely monthly payments, the better your payment history is.
The older the loan is, the better your average age of credit.
Paying off a loan early is a wonderful idea – when there’s an interest rate that’s taking money out of your pocket and putting it into your lender’s pocket.
But you’re paying nothing to have this loan. So, keep it.
Want even more reasons for not paying this off? My friend Ashley Davison makes a good point about late payments. Ashley is the director of operations at Credit Saint, a credit restoration service. She says, “If you have any late payments on your credit, adding more positive months of history will counteract the damage. The more positive/less negative, the higher your score will be.”
Another more technical reason has to do with another factor of your credit score. It’s called “credit mix,” and while it’s only 10 percent of your overall score, it still impacts your number.
“You want to have diversity in your credit profile,” Ashley says, “so closing your only installment account may actually cause harm.”
She points out that your mortgage helps you here. If you didn’t have that—or any other line of installment credit – you could drag down your score. Believe it or not, lenders like to see you borrow money from other lenders. As long as you pay it back on time, it’s a good sign that you’ll pay them back, too.
Finding a better use for your extra cash
Finally, let me talk about something important that has nothing to do with your credit score. You say you have enough saved up to pay off the $5,000 left on your loan. But how much do you have saved up in total? An emergency fund is actually more important than shaving a few points off your credit score. If this pandemic has taught us anything, it’s to be prepared for once-in-a-lifetime life-altering events.
That $5,000 can be used to cover expenses should you get laid off or furloughed, or should you suffer an illness, accident, or natural disaster.
The bottom line is, getting rid of all debt isn’t always good for your bottom line. You have the best kinds of debt, Kayla. The first is a no-interest loan, and the second is a mortgage. Take Ashley’s advice here: “Set up autopay, forget about the car loan, and let it continue to report each month until the end of the loan term.”
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Published by Debt.com, LLC