January 12 2009|03.27 PM UTC

BillShrink Guy

Ask BillShrink Guy: Should We Pay Off Car Loan to Improve Credit?

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A reader of the blog, Andrea from Andrea’s Original, recently sent in a question about car loan and improving credit score:

Hi there. I have a question that maybe you can help me with. My husband has slightly lower than OK credit, and he’s trying to build it up. He did file bankruptcy about 2 years ago. He’s only 27. We have Juniper credit cards which give a free (semi-accurate) credit score, and tips on how to make it better. One of his tips was to get a car loan. So he’s driving his car off the lot today. We do have the money to pay the loan off tomorrow, we could have bought it outright but instead put 6K down and borrowed 4.5K. The payments are roughly $100 a month for 4 years at a rate of 7%.

Ok here’s the actual question. What is the best way to use this loan to increase his overall credit score? Should he pay it month to month, and for how long before paying it off? Should we just pay it off in a month? If we pay it month to month will making 2 payments a month help more? We have a baby due in June, with that comes all the baby expenses including daycare, so I am happy that the monthly payment is so low, but would still like to pay it off sooner rather than later, but repairing his credit is obviously more important.

Thanks! – Andrea

Andrea’s hubby’s dilemma: What’s the best way to use a recently acquired car loan to increase overall credit score?

Need to know terms: (yeah it’s slightly boring but you’ll need to know it)

Installment credit: An installment credit is a type of credit account where you have a fixed number of equal payments through the duration of the payment period.  Examples of installment loans are auto and home loans.  In Andrea’s situation, their car loan has a monthly fixed payment of about $100, at 7% APR, and the loan’s term is 4 years.

Revolving credit: A revolving credit is a type of credit account where you don’t have a fixed number of payment.  Borrowers will continue to be able to have access to credit again and again as they make payment towards account.

A credit card is a prime example of a revolving credit account; for example, you may have a $1,000 credit limit card, and you make $900 in purchases and now you’ll only have $100 left in credit to spend on the account.  Once you pay off the $900, you’ll be able to use your entire $1,000 credit limit account.

Why Would Getting a Car Loan Help Andrea’s Husband’s credit?

Without knowing fully their situation and why the Juniper website made the recommendation, we can assume that a car loan was suggested as a means to mix up her husband’s credit profile.

As listed above, there are two types of credit accounts you should be aware of, installment and revolving credit.  People generally will have a better credit score and credit worthiness if they have a mixture in types of  positive credit accounts.

If all else is equal (age of account, positive payment history, etc.), a person with a mixture of revolving/installment credit should have better credit score than a person without the mixture of accounts.  From a lender’s viewpoint and a credit scoring perspective, this shows that the person in question has been trusted with various type of credit accounts, and was able to manage different type of accounts and paid them on time without issues.

Things Andrea and Her Husband Can Do:

1.  Pay off car loan within the month and save money on interest.

2.  Pay off car loan at regular schedule of ~$100 a month for the next 4 years.

3.  Make double payments per month and pay off the car loan in about 2 years.

In the first scenario, if they pay off the car loan within the month, they will save about $1,200 in interest over the next 4 years.  That’s a lot of money being saved, considering it’s over a quarter of the actual $4,500 loan!  As they’ve already acquired the car loan, the account is already in the credit history.  Once paid off, it would be marked as Paid/Closed, and it would end as a positive credit line in the credit history, thereby improving Andrea’s husband’s credit profile.

In the second scenario, Andrea and her husband can make regular payments at about $100 a month for the next 4 years, but this will end up costing them $1,2000 in interest.  Not a small sum, but because of potential future expenses with the arrival of the awesome newborn, it may also be a good idea to have some cash cushion on hand for difficult times.  If they make regular payments, their credit will slowly be improved as the debt is reduced, the age of account lengthens, and the accumulation of on-time payments continues.

In the third scenario, Andrea and her husband can make double the regular payments per month, thereby reducing the length of the loan duration and save about $600 in interest.  They will also be slowly improving their credit during the loan repayment time, and should arrive to a better credit score slightly faster.

So there you go Andrea!  The first scenario seems like the best way to go in terms of getting immediate benefit from this new installment credit (car loan), and the best way to go to save money on interest charges.  If your husband and your incomes are stable and you’ve already have a healthy cash cushion, then this should be the best course of action.  Suggestion: you can always potentially plan and budget possible expenses for the next 1-2 years, just to see how much of an impact paying off the $4,500 loan will do.

Send Us Your General Personal Finance Questions!

If anyone else reading has further input on this edition of “Ask BillShrink Guy,” please chime in by the comment section.  If you have a general personal finance related question, feel free to Ask BillShrink Guy!

Your questions will be answered in the order they are received. You can also use the comment section in this blog post to ask your question. Please be aware that we may modify or edit your question for brevity and your privacy!

photo credit: thetruthabout

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{ 7 comments… read them below or add one }

Andrea January 13, 2009 at 10:38 am

Hi, It’s the Andrea that asked the question!

We have decided to pay for a few months at double payments and then pay it off all together. We think a combination of all the suggestions may work well for us. Thanks Bill Shrink Guy!

Reply

BillShrink Guy January 13, 2009 at 3:29 pm

Andrea: Thanks for asking the question and letting us share it. Your decision is a great choice. For anyone else that’s reading, you should always be aware that any financial decisions will always work best if you can find a method that works best for you — after all, everyone’s situation is different and requires personal consideration.

Reply

AC January 28, 2010 at 2:28 pm

You should check the loan to make sure there isn’t an early payment penalty. It could definitely cut into any savings you would get from early payment and might actually cost you additional money depending on how early you pay it off in full.

Reply

DL February 24, 2011 at 2:01 am

This was the exact question I’m looking answers for. I only started building my credit history 1.5 years ago and only have 1 credit card. I just bought a new car a few days ago and financed it even though I can pay cash. I’m wondering what the best strategy is for paying it off. The advise to just pay if off completely now contradicts info I found online. Some examples:

http://www.ehow.com/info_7930471_good-pay-car-off-early.html
http://www.carsdirect.com/auto-loans/paying-off-car-loans-early-benefits
http://www.autotropolis.com/wiki/index.php?title=Disadvantages_to_paying_cash

My loan is $20110.00, 4.99% for 60 months. Scenarios I’ve been playing with:

a) pay it all off – save about $2,700 in interest
b) 12 month payoff by making a 1-time extra payment of 16K for the 1st month – total interest paid $170+
c) 6 month payoff by making a 1-time extra payment of 18K for the 1st month – total interest paid is around $100

If building good credit history is my main concern, followed closely by saving financial charges, which one makes most sense? Btw my score is around 700.

Reply

Alex Gutow March 18, 2011 at 4:22 pm

Hi DL,

Thanks for your question! The reason why you’re seeing a lot of different ideas for paying off the car loan is because, like BillShrink Guy said, there is no single “right answer” because it depends on everyone’s situation.

If your main goal is to build credit history, then paying it off all at once will increase your credit score. But, like your articles mentioned, not as much as if you waited 12-24 months. Right now, your credit score is pretty good at 700 and you’re about 40 points away from having excellent credit. Once you hit excellent credit, getting any better has very minimal returns. My suggestion would still be to pay it off right away to get the incremental boost to your credit, but, if you don’t mind losing the ~$200 bucks, you could also just wait it out to get the greatest increase. Unfortunately, it’s difficult to estimate what the exact increase to your credit score will be, but it seems like you’re well on your way to excellent credit no matter what you choose.

Also, as your articles mention, make sure there’s no early payment penalty for the loan to make sure you don’t lose money there.

Good luck and enjoy the new car!

Reply

J. C. September 11, 2011 at 11:25 am

Hi Bill,
My husand and I are trying to buy a home for our children, and we have been told that his credit is an issue and needs some improvement, we are 11 mths away from paying off our current vehicle and would like to pay it off in full will that help to improve his credit score? We have paid consitently for 2 yrs and 7 mths so that should help, right? And if so do you know how long it would take for it to show on his credit report or on or about how many points his credit score will boost after it has been paid off. Thank you Bill!

Reply

KC May 8, 2012 at 3:53 pm

I have a slightly different question. I enrol in Identity Guard and they analyze my credit for negative and positive factors. Here’s the negative – in 2004 I bought a car and SunTrust made a hash of things and opened 2 loan accounts. One in error. The erroneous one started 9/04 and closed paid 10/04. The other one was paid, on time and is now closed. The problem is the erroneous one is still there and I never thought about it until seeing Identity Guard flag it as a negative because it had a such a short payment history. Is this correct? I tried disputing it with both the CB’s and SunTrust but they validated it, despite the real one being there too, with the same open date and everything. Should I pursue this being deleted or just leave it to drop off in 2014? I’m around 720 on that CR so if it will get me closer to 740, it would obviously help. Here’s the exact wording from Identity Guard on why this is a negative:

“Having had credit accounts for a long time is a positive factor because your credit history allows lenders to evaluate how you typically use credit and repay your debts. However, accounts that have been open for a long time may have a short payment history, either because you have not used the account recently, or because the lender has not reported the payment history to the credit bureau. Having short payment histories is a negative factor, even for accounts that have been open for a long time, because it does not provide lenders with the information they need to determine how you repay your debts. Accounts that were opened 40 or more years ago and have 2 or more years of reported payment history are considered best. On the other hand, if your oldest account was opened up to 7 years ago, your credit history may be considered short, and less than 3 years ago is often considered too little.”

Reply

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