Personal loans can be useful if you can pay them off. Sometimes you might need extra time to pay them off or sometimes you may even discover that you can pay them off earlier than expected.
When entering into a loan agreement, you agree to pay back the money to the lender over a set period, which is typically in the form of a monthly payment.
But if you have the option to make an earlier loan repayment will this affect your credit score?
We look at how your credit score is calculated and whether an early loan repayment can positively impact your credit score.
Your ability to manage your money is rated by a credit score. Everyone in the UK has a credit score and this is based on your ability to pay debts on time.
If you pay your bills, for example, your council tax bill or rent and utility bills, in full on time each month, this will help you to improve your credit score. You might have unpaid debts that took longer to pay off or some debt that was written off as you couldn’t pay.
These types of situations will make your credit score less impressive to potential lenders.
Everyone's credit scores are rated between 0 and 999 and five categories determine your score. The categories are excellent, good, average, poor, and very poor.
In the UK the three biggest credit rating agencies have the same categorisations based on your score but there could be some differences.
In theory, paying off a loan early sounds easy. If you are able and willing to pay off a loan early the lender should be happy to receive the payment, right? In reality, the answer is not as straightforward.
Sometimes when paying off a loan earlier you have to pay an interest change fee. There could also be early repayment charges depending on the agreement between the parties.
Sometimes paying off a loan earlier than agreed upon can affect your credit score negatively, even though one would assume this would be a great way to improve your score.
Paying off a loan regularly can help increase your credit score over time. Regular payments are seen as a positive thing by some scoring models.
In some cases you may even see your score dip temporarily after closing a credit account as your credit utilisation ratio, the amount you owe, gets divided by your credit limit.
Leaving a credit card or store card account open after the balance has been paid in full is an easier way to avoid your credit score going down.
Paying off a loan earlier than agreed upon to save money comes down to a few factors:
The loan term
Your financial situation
The interest rate the loan is based on
Whether there are early repayment charges you will be held liable for
The repayment charges may be higher the more time you have left to pay off your loan. Lenders can charge you up to 28 days of interest due to early repayment fees if you have less than 12 months left on a monthly repayment plan.
If you have more than 12 months left on your loan term, an extra 30 days of interest can be added on by lenders.
It is important to make sure you take time to sit down and read your loan agreement. This is so that you fully understand the terms and conditions associated with fees that you could be liable for when paying the loan off earlier.
You may still be able to save money and there are many reasons why someone might want to pay off a loan earlier, other than saving money. If it is the right thing to do will completely depend on your circumstances.
This would depend on what type of debt you are looking at. If you have credit such as a loan or credit card, this would be good for your credit score. If you have credit and you are paying it back on time like you should be according to the agreement, this is good for your credit score and will push it up.
What could be viewed as bad is having no credit history showing that you can pay back borrowed money.
The reason for this is that having credit and paying it back, as promised, shows that you can handle finances while sticking to an agreement.
If you have debt from unpaid loans and credit cards, this will negatively impact your credit score. It will then show that you failed to keep an agreement with repayment and will push your credit score down.
It will show up as a warning to other companies or banks who you are wanting to lend money from.
Building a good credit score is important as it is a determining factor in your ability to borrow money or access products such as credit cards or loans.
Keeping a good credit score is just as important as it also shows potential lenders that you can work with your finances responsibly and pay as per your agreed terms.