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Dear Penny: I Paid Off My Car Loan Early. Why Did My Credit Score Drop?

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Published Apr. 4

Dear Penny,

I paid off my car loan a few payments early, and then my credit score went down 79 points. Why did this happen? How long will it take to recover?

-L.

Dear L.,

Isn't it ironic? Your credit score is supposed to predict how likely you are to repay debt. Yet you paid off your car loan early, only to see your score drop.

I share your pain. Back when I was a credit-challenged twentysomething, I financed a car at an interest rate of what felt like 800%, doubled up on payments and paid off my car two years early. I thought I was on the road (pun intended) to good credit. But to my chagrin, my score fell by about 50 points.

So what gives?

I'm assuming you haven't had any other changes that could affect your credit score, like a late payment or an increase in your credit card balances. That said, it's pretty normal to see a slight drop in your credit scores when you pay off a car loan — or any installment loan, for that matter. This can happen for two reasons.

If your car loan was one of your older accounts, closing the account could have lowered the average age of your credit, which determines 15% of your FICO scores. And your credit mix makes up 10% of your FICO scores. Scoring models reward you for having a mix of revolving credit, like credit cards, and installment loans, like a mortgage or car loan. So if you're closing your only installment loan, closing the account could cause a drop.

Paying off a car loan can hurt your score more if you have a thin credit file — and the fact that your score dropped significantly suggests that this could be the case.

If you have little or no credit available, consider applying for a credit card. If you can't get approved for a regular credit card, try getting a secured card, where you pay a deposit and use that as your line of credit.

Yes, opening new credit can also result in a slight decrease to your score, but in the long run, building a history of making on-time payments and maintaining a low balance on your credit cards are the two most important things you can do to have a healthy score.

The good news: An installment loan that you pay off shows up as closed on your credit reports, but it doesn't disappear. If the account was closed in good standing, it will stay on your reports for about 10 years.

Even more good news: A drop in your credit score after paying off a loan is usually only temporary. After a few months, your scores will probably rebound. Mine did after about three months.

The bottom line: Don't worry too much about your credit score for now. You've made a smart money move. You have one less bill to pay. You have extra cash each month. Spend it wisely.

Now go forth and enjoy the open road knowing you're no longer tethered to a car payment.

Dear Penny is a personal finance advice column produced by the Penny Hoarder. Have a tricky money dilemma? Write Dear Penny at askpenny@thepennyhoarder.com and you might see your question answered in an upcoming column.

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