A FICO credit score can make an impact on your financial life in a number of ways. It can help determine if you're approved for a credit card, the interest rate you'll receive on a loan and even if you'll qualify for a particular job. Having a higher score is important, and paying off a car loan may help improve that number.
Understanding Your Credit
How much debt you owe on all of your credit accounts appears on your credit report. FICO considers this debt information when calculating your credit score. The amount of debt you owe represents 30 percent of your FICO score and is the second-biggest component in the calculation of the score. This percentage includes debt on revolving accounts, such as credit cards, but it also includes car loan amounts.
Paying down an installment loan, including a car loan, will improve your score, FICO says. When you take out an installment loan, the lender reports a beginning balance to the credit bureau. As you make your scheduled payments, that balance drops. As the balance on the loan drops, your credit score improves. The bigger the gap between the amount you began with on the installment loan and the amount left on it, the more positive of an affect it will have on your credit score.
Paying off a car loan can help improve your credit. However, depending upon how you do it, your score may not benefit from paying it off. For instance, if you take out a $10,000 personal loan to pay off the $10,000 balance on the car loan, the car loan is paid off but you have really just traded one loan for another, so this may not improve your score. This is because your FICO score looks at your total debt levels when calculating your score. Although you paid off one debt, you still have the same overall amount of debt present on your report via the existence of the new debt. To improve a score, pay off debts to reduce your overall debt level instead of moving the debt around from one source to another.
Paying off a car loan will eliminate the loan debt, which may help your score, but it won't remove the previous payment history on the account. This payment history is the major contributor to your FICO score calculations. It represents 35 percent of your score. Positive payment history remains on a report for up to 10 years. Negative payment history can remain for up to seven years. For the best score, FICO suggests not only paying down debt levels but also ensuring that payments on all credit accounts, including installment loans, are on time and meet at least the minimum payment requirements of the credit issuer.
Mack Mitzsheva is a tax lawyer, personal finance expert and the author of the forthcoming ebook, "10 Best Places to Work Online." Mitzsheva is also a social media entrepreneur with five successful sites under her belt. Always innovative, Mitzsheva is currently developing a cutting-edge budgeting app for newlyweds.