Qualifying for credit involves more than a strong credit rating; your debt-to-income ratio is also an important part of the equation. Paying off loans early can positively affect your credit rating in several ways, as well as reduce your overall debt-to-income ratio. Always check the fine print on any loan to determine if there are penalties involved for early pay-offs. If you have more than one loan, pay off the ones with the highest interest rates first.
Payment History
A consumer's payment history accounts for the greatest percentage in calculating credit scores---35 percent. Paying off loans early or on-time translates positively into a 'paid as agreed' listing on your credit file. Negative items may be removed from your credit file after seven years, but positive account listings can remain indefinitely.
Credit-to-Debt
Your credit-to-debt ratio is the second largest factor to affect your overall credit score---30 percent. Paying off loans early can affect your credit score positively, especially if you do not close the account. Some accounts, such as vehicle or mortgage loans, must be closed when paid in full, but paid-off credit cards and other revolving accounts that remain open show more available credit with no debt attached.
To calculate your credit-to-debt ratio, divide your total amount of outstanding debt by your total available credit. For instance, if you owe $10,000 and have $25,000 in available credit---include the credit on paid-off revolving loans---then your credit-to-debt ratio is 40 percent. Credit-to-debt ratios that exceed 50 percent negatively affect your credit score.
Debt-to-Income
In addition to your credit rating, potential lenders calculate your debt-to-income---DTI---ratio to determine your creditworthiness. Paying off loans early decreases your DTI, which may help you qualify for a better interest rate or a lower down payment for the credit you seek. Compute your debt-to-income ratio by dividing the total amount of recurring debt per month by the total gross monthly income. A DTI that is lower than .36 is favorable for many lenders.
Other Factors
Paying off loans early will not affect the three remaining factors in a credit score calculation. New credit accounts for 10 percent of the overall score. Odds are that the loan you are paying off is older than six months, so the new credit category is not affected. When you opened the credit account that you are paying off, both the length of credit history---15 percent---and the types of credit used---10 percent---categories were affected.
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