Many financial advisors will tell you that it’s a bad move to buy a new car, and to be fair, they’ve got a point. The fastest depreciation of a vehicle’s value occurs in the first couple of years, and you definitely get more for your money if you buy a car that is a few years old. However, there’s more to any life decision than just considering what is financially the best move.
For me, I prefer the peace of mind that comes with a new car. I get a factory warranty on the vehicle and I don’t have to worry about whether a previous owner took good care of it or drove it aggressively. Plus, I like to keep the same vehicle for a long time, so I’m not that concerned about how the retail or trade-in value evolves over time.
I bought a new Ford Expedition a few years ago. For a new car, I did it in a very financial advisor-ish way, as my car was a leftover from the previous model year and I got a substantial discount because the dealership wanted to get rid of it. Even so, it was too much to pay in cash, and since this was the era of ultra-low-interest financing, I got a car loan with a sub-4% interest rate.
Well, earlier in 2024 I finished paying the loan off (more than a year early). And as soon as the “paid in full” designation hit my credit report, my FICO® Score dropped by about 10 points.
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Why paying off a loan can make your credit score fall
Now, it might sound counterintuitive that a paid-off car loan (which is clearly an example of responsible credit behavior) would adversely affect your score. But if we take a closer look at how the FICO scoring formula works, it makes a lot of sense.
One key point to know before we go on is that a paid-off loan is officially considered to be a closed account. And because of this, it can have some negative implications on your credit score. You may have heard that closing an older credit card can drop your credit score. The same thing applies here.
The reason primarily has to do with the “amounts owed” category of the FICO formula, which makes up 30% of your credit score.
Instead of focusing on the actual dollar amounts you owe to creditors, it considers how much you owe on your credit cards relative to your total credit limit and the amount you owe on installment loans relative to the original balance.
In other words, a car loan that is 95% paid off can be a rather positive factor in your FICO® Score, especially if it has a flawless payment history. On the other hand, once you’ve made the last payment, it shows up as a closed account and is no longer a positive influence on your score.
In addition to the amounts owed category, there are two other ways paying off my car loan may have impacted my credit score
Length of credit history (15% of my score): This category considers time-related factors, such as the age of your credit accounts. Because my car loan had been established for several years and is the older of two non-mortgage installment loans on my credit report, it could have affected this area of the scoring formula.
Credit mix (10% of my score): In a nutshell, lenders want to see that you can be responsible with a variety of different forms of credit, so the FICO formula rewards a diverse mix of accounts. By removing my only auto loan, it could have made my credit mix less favorable.
I didn’t mind the drop
Even though my FICO® Score fell by about 10 points in response to paying off my car loan, I wasn’t bothered by it. For one thing, I’ve been a financial planner for a while now, and am very familiar with how actions like this factor into the credit scoring formula. And my score was far enough into the realm of excellent credit that it remained there, even after a 10-point decline.
More importantly, a minor drop in my credit score is nothing compared to the elimination of that monthly payment from my budget, the fact that my car title is physically in my possession, and that by paying the loan off early, I’m saving about $1,000 in interest.