What to Expect After Paying Off an Installment Loan

Paying off a loan is a major milestone. Whether you’ve finally cleared your student debt, paid off a home improvement loan or own your car outright, making your last loan payment calls for celebration.

But before the balance hits zero, there are a few things to know and prepare for, especially if you’re considering paying off a loan early.

4 effects of paying off an installment loan

Here’s what can happen — and what you can do — once you pay off your loan.

1. Your credit score may dip

You read that right: Paying off a debt can cause your credit score to drop.

The length of your credit history and your credit mix are two factors that affect your credit score. Paying off an installment loan that’s your oldest form of credit or the only installment credit you have (as opposed to credit cards’ revolving credit) could cause your score to go down.

The good news is that this dip in your credit score is likely temporary. Continue making on-time payments toward other loans and credit cards to strengthen your credit.

2. Your debt-to-income ratio will drop

Your debt-to-income ratio is the percentage of your monthly income that goes toward debt payments. When you eliminate a debt payment by paying off a loan, this number will be lower — and that’s a good thing.

For example, say you earn $2,000 per month. If $500 goes toward a personal loan payment, and you spend an additional $300 on an auto loan payment, your DTI would be 40%. Once you pay off the auto loan, it will be 25%.

Lenders use DTI — among other factors — to determine whether you can afford the monthly payment on a new personal loan, mortgage or auto loan. The lower the number, the better.

3. You’ll have extra money in your monthly budget

Once the cash you used for loan payments is free, you can put it to work. Here are a few options:

• Start or add to an emergency fund. NerdWallet recommends working toward $500 and then striving for three to six months of living expenses.

• Save for retirement. If you have a 401(k), chip in enough money to meet your employer’s match, if they offer one. If you can contribute more, most financial experts recommend putting 10% to 15% of your pretax income in a 401(k) or IRA.

• Pay off other high-interest debt. Putting extra money toward credit card or high-interest loan payments will help pay down that debt faster.

• Save for your next big goal. That could be a down payment on a house, your kids’ college education or a dream vacation.

4. You may qualify for lower rates

With a lower DTI ratio and a better credit score, you may qualify for a lower annual percentage rate on a new personal loan. Pre-qualify with multiple lenders to check and compare potential loan rates without hurting your credit score.

» MORE: Best personal loan interest rates

Shopping around for the best mortgage or auto loan may require a hard pull of your credit before preapproval, which can cause a temporary dip in your score. However, you can minimize the impact to your credit by seeking multiple loan preapprovals within a specific time frame (typically between 14 and 45 days).

Paying off an installment loan may also put you in a better position to refinance existing loans or credit cards at a lower rate. Refinancing can lower your monthly debt payments and reduce the amount of interest you’ll pay over time.

What to know before paying off a loan early

You may be tempted to pay off an installment loan early to save on interest and get rid of the monthly payments. However, there are a couple of things to consider before making plans to eliminate the debt ahead of schedule.

• Your loan could come with a prepayment penalty. Some lenders charge a fee to make up for the interest payments they’d miss out on if a borrower pays the loan off early. Not all loans include prepayment penalties, so make sure to read the fine print of your loan agreement.

• You could shortchange other financial goals. Funneling all your extra cash to pay down a loan early means you might have to sacrifice building an emergency fund, saving for retirement or meeting other financial goals. Take time to weigh all your options before committing to an early debt payoff plan.