Does paying off a loan help credit?

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Does paying off a loan help credit

One’s credit score is very impactful when it comes to their personal finances. A low credit score can make funding various life expenses increasingly more challenging, not to mention more expensive, while a good or even great credit score can save you quite a bit of money in interest expenses.

Plus, it will be a lot easier for you to get a loan to purchase something. If you’re looking to improve your credit score, you may be wondering if paying off debt helps your credit score. Let’s explore this question in greater detail below. 

What is your credit score?

First and foremost, what is your credit score? Simply put, one’s credit score is a numerical value that indicates how financially responsible one is when it comes to paying their financial obligations on time. 

What exactly does the above mean? Let’s review an example. Imagine if you have hundreds of power tools. From drills to various saws, your garage is like a mini hardware store. You have two neighbors who always ask you to borrow your tools. 

One neighbor, Tom, borrows the tool and returns it on time and in great working condition. Tom would be creditworthy. Joe borrows your tools and often loses them, breaks them, or takes months to return them. Joe would not be creditworthy. 

Your credit score shows financial institutions how responsible you are for returning what you were given. This applies to your cable bill, cell phone bill, student loans, mortgage, credit card debt, and just about any financial obligation you have in your life! 

Why is your credit score so important?

Unless you have all the money in the world, and you never need to borrow a dime from anyone, you will have a loan at some point in your life. Your credit score plays a key role in determining what the terms and conditions of the loan are. 

If you have a low credit score, a bank may deny giving you a loan or will give you a loan at a high interest rate. If you have a good credit score, you are more than likely approved for the loan, and the interest rate will be lower, which ultimately saves you money. 

Credit: a catch-22 

Credit is a catch-22. If you don’t have credit, a lender may be reluctant to lend you money. However, you need to be lent something in order for you to begin building your credit score. You can build your credit score by putting a bill in your name, taking out a small loan, or opening a credit card. 

Putting a bill in your name

If you have a cell phone, or a cable/internet, start off by putting those expenses in your name. Pay your bill on time and in full each month, and your credit score will rise. 

Take out a small loan

Getting approved for a small personal loan is easier than getting approved for a large loan. Even if you don’t need the money, having a $1,000 – $2,000 personal loan, and repaying the balance consistently every month, will help improve your credit score. 

Open a credit card

Similar to the above point, a credit card is a great way to improve your credit score. It can also hurt your credit score if you don’t use it properly, or if you max it out. But if you want to keep your debt minimal and still improve your credit score, get a credit card and pay for small expenses on it each week. Pay off the credit card, in full, every month. 

Does debt hurt credit? 

If debt is needed to build credit, does debt hurt credit? This is the gray area of credit scores. Banks do not want to see you max out your leverage, or drown in debt, but they certainly want to see you have some debt obligation each month so they can gauge how financially responsible you are. 

There are two main types of debt:

  1. Installment Loans: These are loans that you take out and promise to pay back over the course of X number of months or X number of years. Common installment loans include; student loans, mortgages, or car payments.
  2. Credit card debt: Credit card debt is a massive debt category that impacts millions of Americans. Credit cards typically come with high interest rates. It is so easy to spend money via a credit card, which compounds the debt problem.

Generally speaking, paying off your credit card does not negatively impact your credit score. In fact, it can do wonders for your debt-to-income ratio, which is another vitally important financial ratio. 

Paying off installment loans quicker than the term period can temporarily impact your credit score, but the negative side effect is not long lasting. Typically within 30-60 days, your credit score bounces back, and you are in a much better financial position considering the lower debt-to-income ratio you will have. 

Something to be mindful of with lending is the fact that lenders want to get paid back and receive the interest payments. If you are constantly paying off your installment loans well ahead of schedule, the interest payments haven’t fully run their course. Lenders make money on those interest payments, and they will ultimately make less money if they aren’t receiving payments for the full term of the loan they gave you. 

Know your options

Personal finance is exactly what it sounds like: personal. There are some general rules and assumptions that can be applicable to the masses, but everyone has their own personal financial responsibilities and circumstances. 

Paying off your debt to improve your credit score is one option you can take, but it may not be the best one. Having the right financial tools available, including the right bank account, will ensure you are making the right financial choices. 

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