Smart Money Podcast: Redlining, and Paying Off a Car Loan

Sean Pyles: Welcome to the NerdWallet Smart Money podcast, where we answer your personal finance questions and help you feel a little smarter about what you do with your money. I'm Sean Pyles. If you want your money questions answered on a future episode, turn to the Nerds. You can call or text us on the Nerd Hotline at 901-730-6373. That's 901-730-NERD. Or you can email us at [email protected]. This episode, my co-host Liz Weston and I answer a listener's question about whether paying off a loan early will harm your credit. But first, I'm joined by NerdWallet mortgage writer Linda Bell for a conversation about her recent article on redlining and its effects on black homeownership and the racial wealth gap. So hey, Linda, welcome to the Smart Money podcast.

Linda Bell: Thank you so much, Sean. I'm happy to be here.

Sean: It's so good to have you on, I've been meaning to have you on for a while now, so I'm glad we can finally get this going. Over the past year our collective awareness around our country's legacy of racism and the myriad ways it has manifested over centuries and up until the present has really come into stark relief, and redlining as a practice has received a lot of attention. But many are still unaware of what this practice is and how we're still seeing the effects today. So, to start, can you give us an explanation of what redlining is?

Linda: Well, redlining is when someone is denied a mortgage based on their race or where they live, not their creditworthiness. Now, we saw this emerge in the 1930s after the Great Depression, all these color-coded maps were created to assess the risk of lending, but instead they were based on race. So there were neighborhoods that were colored green and blue, those were areas that were predominantly white, and those were considered the least risky neighborhoods. But then when you go on the opposite side of the spectrum, you had blacks and other families like Jewish, Asian families, were considered to be in areas that were risky. And they were typically shaded in red, hence the term redlining, and those areas were considered hazardous, and almost no lender would lend to anybody in those areas.

Sean: And this was a government policy of discrimination, which I think is really important to note. It's not like it was some random company doing this. It was the U.S. government saying these predominantly black neighborhoods are not areas that we want to lend to, and we shouldn't give out mortgages to these people.

Linda: Yes, especially the Federal Housing Administration, which FHA loans are supposed to be this beacon of hope for people in providing low-cost loans, and the Federal Housing Administration was involved in this as well.

Sean: Redlining isn't the first time there's been this historical discrimination around housing in particular. Going back to the post-Emancipation era, we know that newly freed Black Americans were not given that 40 acres and a mule that they were promised, but after 246 years of being enslaved, Black people in America were given practically no assistance after being freed. And then they were also financially discriminated against when they did try to buy houses, they were charged higher prices. And even when they worked as sharecroppers, they were often paid less for their work compared to their white counterparts.

Linda: Yes. So there's a lot of history there. Newly freed slaves, no education, no means to support themselves and move forward. And it's that generational wealth that we talk about when we talk about redlining a lot, is that Blacks were not able to build that and pass that property, that home on generation to generation to generation, which is why we see the wealth gap today. But also racial covenants, those were contained in deeds — and actually still contained in deeds today, though they're not enforceable — that actually prevented the sale or the rental of property to Black people and people of color. You know, homeownership, a hard thing to access after 40 acres and a mule, but it continuously, even before the term quote unquote redlining was coined, [Black people] were prevented from owning or renting properties because of these racial covenants.

We definitely want people to keep in mind that it still exists today. Maybe not redlining as it officially was in the 1930s and after, but it still exists today in home appraisals; we're seeing that people of color are discriminated when it comes to appraisals. This story of this black family tried to appraise their home and when they switched it up and they had their white friend do it, they got a higher appraisal on their home. Things like this discrimination still happens. And I just want to encourage people just to read more, understand more, and to support people that are trying to become homeowners.

Sean: One thing you said earlier about intergenerational wealth is so important to focus in on because in America, in the United States, one of the most significant ways that people can build wealth is through homeownership, and white Americans were given a gigantic head start in this regard, which is why we see such a disparity between white wealth in America and Black wealth in America.

Linda: Yes, we definitely see that. When I wrote my article, I was very startled by these numbers. It was courtesy of the Federal Reserve, the 2019 data: $188,200, white families' median wealth, compared to Black families' $24,000. So that's $188,000 compared to $24,000. That's a big disparity. And the homeownership gap, the lack of generational wealth; I mean, it's a number of factors, but the homeownership gap is one of the big reasons why we're seeing the racial wealth gap today.

Sean: One thing that's also startling is how huge this impact is on our economy at large. Economists at Citi say that if the racial wealth gap was closed today, it would actually add $5 trillion to the economy over the next five years.

Linda: Yeah. There's a lot of work to be done in terms of the homeownership gap and the racial wealth gap. The economy affects individuals, and this racial wealth gap, it can affect our whole economy and it's affecting our whole economy, and the economy and our whole nation would be stronger if we would only understand, "OK, there's this gap here and let's do what we can to bridge it, to close it." Because there's a stark difference between the haves and have-nots, and we really need to make sure that have-nots are able to have.

Sean: And I wish that people would care about this beyond just its effect on the economy, obviously these are humans who deserve a life of respect and prosperity, but sometimes that is the only thing it takes is people understanding that there is a true economic dollar value and cost to all of this.

Linda: Yes. And you have to make that connection to some people. Because I think some people understand, "OK, this exists," and then say, "Well, there's nothing that could be done about it. Oh, well, this is the past," but this is the now, this is not, "Redlining, oh, it was in the 1930s and here we are today." No, it was in the 1930s and it still exists today. And a lot of the discriminatory practices we see happening in various areas like appraisals, or that Black people receive higher-cost loans than their counterparts. So we're still seeing discrimination exist today and it's important that we call it out and look for solutions.

Sean: And that's why it's so important to have these conversations so that we can know how we got to where we are, so we can begin to organize around making a more just and equitable future. One thing that really stood out to me in your piece is that you discussed strategies for overcoming racial disparities in homeownership. And can you outline a few of those?

Linda: Yes, definitely. I'll back this up a little bit and say that the Fair Housing Act made redlining illegal, but a specific law has not been passed to address the history of discrimination that black people have experienced in housing. So I think there needs to be a law that addresses, for example, down payment assistance. It's hard to get a down payment for most people, but specifically for Black individuals as well. And also the expansion of alternative credit scoring models. This is something where it could open the door for more people of color to become homeowners and allow a good payment history when paying your rent or a good payment history when you're paying your utility bills.

But I also want to encourage prospective Black homeowners to research the different opportunities and grants that are available. NerdWallet has this great state home buyer page that highlights the different loans that are available, reduced interest rates, low down payment, closing cost assistance. Like I always say, knowledge is power, and I encourage people to go out there and get as much knowledge as they can about this redlining, but also on ways that they can actually lift themselves up.

Sean: Well, thank you so much.

Linda: Sure. Thank you, Sean.

Sean: All right. And with that, let's get on to this episode's money question.

Liz Weston: Which comes from a mysterious nameless listener. They sent us a text asking, "I'm starting a master's program in the fall and I have two years left on my car loan with a 3.24% interest rate. Because I have income now and I won't once I start school again, I'm thinking about paying off my car loan before starting. There's no penalty for paying off my car loan early. Should I be worried that paying off my car loan early will negatively affect my credit history? I want to take out a mortgage in a few years."

Sean: Great question, dear nameless listener. To help us answer this, we're joined once again by our go-to credit pro, Bev O'Shea. Hey Bev, welcome back to the show.

Bev O'Shea: Hi Sean. Thanks for having me back.

Liz: So Bev, I think we can cut to the chase and say that yes, paying off a car loan early could result in your credit scores dropping. Can you explain why that is?

Bev: Yes, because you will have one less active, open installment loan on your credit report, and a credit report rewards you for having more lines of credit and having them paid on time.

Liz: It won't disappear from your credit report, it's just not actively contributing to it anymore. Is that right?

Bev: That's exactly right. If you have another installment loan, like a student loan, the difference should not be dramatic. You probably don't have much to worry about in terms of your score dropping so that you won't qualify for a mortgage in a few years.

Sean: This listener is in grad school, and so I think it might be safe to assume that they probably have loans from undergrad, which means that not having this car loan probably won't be a huge deal in terms of the mix of lines of credit on their credit report.

Bev: Right. I would be more concerned about whether paying off this loan early will leave them with enough money for an emergency fund.

Sean: Well, one other follow-up question I have before we get into that is around maybe how much their credit scores could drop. Do you have any idea of what the number change might look like?

Bev: It's going to vary by credit score. One way to get an idea is to use a credit score simulator. NerdWallet has one. That's a good way to sort of test drive a financial move that you're thinking about making.

Sean: One thing I really like about the simulator that we have and the page we have that explains what goes into your credit score is that you can see that not having a loan on your credit report will not do as much damage as say, missing a payment. Any sort of derogatory mark like that will have a much bigger impact because it's showing that you're not meeting your obligations versus just having one fewer line of credit on your report.

Bev: Exactly right, Sean. And you can replace that particular loan if you wish. A lot of people, when they pay off one car loan, they end up taking out another if they trade their car in. It's possible to have an excellent credit score with no credit cards. It's possible to have an excellent credit score with no installment loans. But you've got to have one or the other and pay it consistently.

Sean: So you've been basically saying that what's really important here is the mix of credit on their credit report and how that goes into factoring their score. But our listener was wondering about whether the real damage might come from not having this loan and it shortening their credit history. How concerned or not do you think they should be about that?

Bev: I think they shouldn't be very concerned about that. They will continue to have a credit history as long as they continue to have credit and repay it as agreed.

Liz: And, as we mentioned, this loan will continue to be on the credit report. So it's not like you pay it off and it disappears entirely. So it's there. And I said it wasn't contributing; technically it is. It's just not an active account, so it doesn't contribute the maximum that it could. As we've mentioned, it makes a big difference if you have a bunch of different accounts on your credit. Or if you have a few, the damage tends to be bigger when you close an account, or if it's your only installment loan, that can be a problem. I wanted to mention that I love the fact that our listener is concerned about getting a mortgage and is concerned about credit scores and credit reports and all that. But can it be taken too far? It seems like a lot of people with good credit worry excessively about this. What do you think, Bev?

Bev: I think they do. Credit is something that's a tool more than it's a goal, really. Because the reason that you want good credit is so that you can use it. And a lot of people are very afraid to use their good credit because their score could drop a few points. And sometimes when you're using your good credit, it's fine for your score to drop a few points. Once you've hit about 740, you're fine. If you've got an 800 or an 825, and you're worried that your score is going to drop into the 780s, you can go ahead and let it. It's not going to cost you a penny extra interest and it's not going to keep you from being approved.

Liz: Because once you get to the certain point, you're going to get the best rate and terms no matter what, right?

Bev: Yeah.

Liz: Although we're being a little hypocritical here because as we all know, there's a competition going on here at NerdWallet about getting a perfect score. And we know we can't keep it once we get it because credit scores change all the time. But I think, Bev, you've gotten there, right?

Bev: I've gotten there, yeah. And I took a screenshot of it because I knew it wasn't going to stay.

Liz: Yep. Bragging rights, baby. It's worth it.

Sean: But that's pretty much all you're going to get with this, which is fun to have especially because at NerdWallet we're so focused on how even the smallest changes in something like your utilization can make your score go up a few points in one week to the next. But for the purposes of our listener, it really doesn't matter all that much. And I think it's really important to have that perspective and not get too caught up on these small changes. It's really not going to hurt you, especially if you're not going to get a mortgage for a few years.

Liz: We also probably should mention that some credit scores react much more strongly to certain things than other credit scores. And just say again, there are many, many, many different credit scoring formulas. So your mileage may vary.

Sean: Right. Well, that actually raises another topic I wanted to talk about, which is the different factors that go into credit scores. Again, plural, multiple scores here. Bev, can you lay out a few of the key elements that go into credit scores and how installment accounts are weighed?

Bev: I can. The very most important thing for every credit score out there is paying on time. After paying on time is something called credit utilization, that you mentioned earlier. Credit utilization is how much of your available credit you're actually using. So if you have a credit limit of, say $10,000, and you're using $3,000, then you've got a credit utilization of 30%, and that's about the highest that you would want for a good credit score. Credit mix is a much smaller factor, but it does weigh into your credit, and that is credit scores will reward you for having more than one type of credit. And that would be installment loans, where you have even payments over a set period of time, and credit cards, where you get to manage how much you pay back each month.

Sean: One thing I also want to plug is we have an article that is about credit mix and how it affects your credit score. And there's a handy chart on here that shows five different factors that go into your score. So payment history is by far the largest, followed by utilization, then length of credit history, and mix of credit types is all the way at the far end, right next to recent applications. And it's pretty small. You can see proportionally how much that may affect your credit compared to payment history.

Bev: The best way to get and keep a good credit score is to pay on time, every time, use your credit lightly — meaning don't use your whole credit limit — and to keep your credit accounts open unless there's a compelling reason to close them. And a compelling reason would be very poor customer service, it could be high fees, or feeling like that you're not getting your money's worth out of it. This past year, I canceled a card that had an annual fee because it was a travel card. I knew I wasn't going to get my money's worth out of it. And my credit score dropped because it had a high credit limit, so it caused my overall credit utilization to go up a little bit.

Sean: I'm actually currently debating canceling two credit cards because of their annual fees and because I don't really use these cards very much, but I'm actually concerned about the dip that may happen to my credit scores, especially because I'm anticipating a hard credit pull as my mortgage gets finalized in the coming months or so. I'm wondering how much your credit scores dipped when you did close those accounts?

Bev: You don't want to know. It was almost 30 points in the month after I did it, but the month after I did it was also shortly after I had refinanced a mortgage. So my advice would be to get the mortgage first and get that signed and out of the way before you do something that could risk lowering your credit score.

Sean: I'm also thinking of calling my issuers and maybe playing a bit of hardball, asking if they can waive the fees this year. Have you guys ever done that?

Liz: Oh yeah. And actually, you want to talk about this in a very specific way. You don't want to say, "I'm going to cancel my card," because then you might not get the retention offer. So you say, "I'm thinking about canceling my card," see what they come up with. The other thing you can do, if you don't like the retention offer, is simply ask for a product change. Almost always there's a card by the same issuer and usually within the same family of cards, that has a zero fee option. So that's definitely a way to go.

Sean: Bev, what are your go-to two or three tips for someone if they want to raise their credit score quickly?

Bev: Well, if you want to raise it quickly, be sure that you're avoiding doing any of the things that can damage your score. Because if you're late with even one payment, almost everything that you're doing to bring up your score is not going to work. That is really huge.

Liz: At least in the short run, right?

Bev: Yeah, this is in the short run. Time and paying on time will cure almost anything that you've done wrong. There's also paying attention to credit utilization because that's your second-largest factor and it's pretty big. You've got to whittle down your balances, and best of all, pay them off every month.

Sean: I know that I mentioned earlier about how it's good to have perspective on what your credit score is and how it can change from one week to the next. But that said, I will admit to paying off my credit card almost daily because I like to keep my utilization as low as possible and my score as high as possible, even though I know it doesn't matter, it's more of a vanity measure for myself. So call me a hypocrite, but that's something that I do because I do want to maintain that high score personally.

Liz: I think you want to show a tiny balance on one of those cards though, I've heard about the all-zero-but-one approach to it. And basically what we're talking about is the lower your credit utilization the better. We don't want you to carry credit card balances at all, period. We're talking about how much you actually use the card. So you want to keep your use under, ideally, 10% if at all possible. And there are some people who seem to get good results by paying off every card in full so it's got a zero balance on the statement closing date, but having one that has some sort of a balance. And I don't know why that would work particularly, but maybe it's just because you're showing activity.

Bev: I do, yeah.

Liz: OK. Tell us why.

Bev: It is because when credit scores are looking at balances, the credit score will reward you for a lower balance until you get to 1%. 0% actually is not as good as 1%. That's based on their algorithms that are based on what they actually see with people.

Liz: OK. So you want to show some activity on at least one account.

Bev: Exactly.

Sean: Well, one thing we touched on before was how to think about your credit score in relation to other financial goals you might have. And Bev, you mentioned emergency funds being something to think about here. So what are your thoughts on that? How maintaining a good credit score should stack up compared to something like making sure that you do have enough cash if you're about to not have an income.

Bev: I would prioritize the emergency fund over the credit score. I think you can do both, but at the same time, if push comes to shove, you want to have an emergency fund so that you don't start becoming late on your credit cards, if you're having to rely on them. You really want to keep your credit score decent if you can, because you're going to need the credit. If you have excellent credit and no emergency fund, and you're late because you don't have any money, then your credit score is gone.

Liz: One of the things that we've got to point out is that they're not going to save very much on interest by paying this loan off early. What they are going to do is tie up money that they could use somewhere else, like in their emergency fund. And they're potentially doing damage to their credit score, even if it's temporary. So there doesn't seem to be a huge reason to do this.

Sean: Besides just having some extra cash monthly. But again, it's not going to be a huge amount, right?

Bev: I don't think it's going to save them a huge amount, no.

Liz: So, if they borrowed, say, $20,000 at that interest rate and they borrowed it for four years, their payment's going to be around $450 a month, a little bit less. So that is a chunk of change. That's understandable that they might want to get rid of it. But in the grander scheme of things, they're not saving that much interest. They're tying up money that they could use somewhere else. They're potentially doing damage to their credit score. So why bother?

Sean: All right. Well Bev, thank you for sharing your insights, as always. Do you have any final notes for our dear nameless listener?

Bev: I think the main thing is be sure that you're not letting a credit drop of a few points drive your whole decision-making process, because you've got more to think about, a much bigger picture than that.

Sean: OK. Well, thank you so much.

Bev: You're welcome. Anytime, Sean.

Sean: With that, I think we can get on to our takeaway tips, and I can kick us off. First tip, know the factors that influence your credit scores. Closing an installment account might lower your score, but building a history of on-time payments is more important.

Liz: Balance the effect on your scores with your goals. Your credit score shouldn't be the only factor you consider.

Sean: Lastly, put your scores in perspective. Dropping a few points from paying off a loan isn't the end of the world, especially if you have a good or excellent credit score.

And that is all we have for this episode. Do you have a money question of your own? Turn to the Nerds and call or text us your questions at 901-730-6373. That's 901-730-NERD. You can also email us at [email protected] and visit nerdwallet.com/podcast for more info on this episode. And remember to subscribe, rate and review us wherever you're getting this podcast.

Liz: And here's our brief disclaimer, thoughtfully crafted by NerdWallet's legal team. Your questions are answered by knowledgeable and talented finance writers, but we are not financial or investment advisors. This Nerdy info is provided for general educational and entertainment purposes and may not apply to your specific circumstances.