Paying off debt is a huge win, so you might be disappointed to find out that paying off debt can cause a drop in your credit score. While seeing the points drop in your credit score can feel like a loss, understanding why can help you make a plan to bump your score back up. Understand the factors that impact your credit score and how you can keep your score in good standing even after paying off debt.
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Why did my credit score drop after paying off my loan?
Your credit score is calculated using a specific formula. Your score is an indicator for how likely you are to pay back a loan on time. Several factors contribute to the credit score formula, and paying off debt does not positively affect all of them. Paying off debt may lower your credit score if it changes your credit mix, credit utilization or average account age. Here are some scenarios that could negatively affect your credit score:
- You eliminated your only installment loan or revolving debt: Creditors like to see that you’re able to manage various types of debt. If eliminating a particular debt makes your credit report less diverse, it can negatively affect your score. For example, if you pay off an auto loan and are left with only credit cards, your credit mix suffers.
- You’ve increased your overall credit utilization: Keeping the overall utilization of your available credit low (in other words, not maxing out all of your credit cards or lines of credit) results in a better score. But when you pay off a revolving line of credit or credit card in its entirety and close the account or let the account go inactive (which often leads to it being closed), it decreases the total amount of credit you have available, potentially increasing your remaining utilization rate.
- You’ve lowered the average age of your accounts: The longer your accounts have been open and in good standing, the better. Having a 20-year old account on your report is a good sign, even if you don’t use it; closing that account and being left with accounts no more than five years old dramatically reduces the average age of your accounts.
Should I apply for another loan?
If you have paid off a debt and are looking to keep up your credit score, you may be wondering what you can do. If you close a loan, it may seem like opening another loan will keep your credit score points high. However, applying for another loan may only help your credit score in certain scenarios.
If the loan you closed was held for a while, meaning you had a long credit history with that loan, opening a new loan won’t help with any credit score points lost. A new account won’t bring you any wins with credit history length.
However, if paying off a loan means you lose some diversity in your credit portfolio, applying for certain types of loans could help your score. You get some points for having different types of credit (i.e. credit cards, auto loans, student loans, home loans, etc.). If the loan you pay off is the only one you have of its kind, you could gain some points back by opening a new type of loan. For example, if you pay off your car loan and are left with only credit cards, consider applying for a different type of loan.
A bigger contributing factor than credit mix for your credit score is whether you can make payments on time. If applying for a new loan will impact your ability to make any payments on time, you shouldn’t risk applying for the new loan.
How credit scores are calculated
FICO scores are calculated using five key factors: payment history (35 percent), credit utilization/amounts owed (30 percent), length of credit history (15 percent), credit mix (10 percent) and new credit (10 percent).
Your credit score is heavily influenced by how often you make timely payments on your accounts. Missing payments or defaulting on loans will tank your score quickly.
Paying off your debt shouldn’t affect this aspect of your credit score. However, it’s still an important consideration. If you deliberately miss payments in order to keep an account open longer and avoid other negative effects of paying off debt, your credit score will suffer.
One area directly affected after you pay off debt is your credit utilization. Your utilization is calculated by dividing the balances you carry by your total credit limit across all of your cards.
This category of your credit score includes your credit utilization ratio for each credit card as well as your overall balances. Ideally, your balances should be between 10 and 30 percent of your available credit. If you paid off an account that had a low balance but your other cards are close to being maxed out, you may still see poor credit utilization. You can also be impacted if you pay off all of your debt and have no credit utilization.
Length of credit history
The average age of your credit accounts is another important factor in determining your credit score. Having many older accounts has a positive impact on your credit score, and having several new accounts is a negative contributing factor. If you pay off debt on an older account and subsequently close it, your credit score may drop.
Installment loans (like car loans, student loans or home mortgages) have a set period in which they will be paid off. Credit card debt is considered “revolving” debt, which varies from month to month and does not have a set time period to repay. Installment loans don’t impact your score as heavily as revolving debts like credit cards and lines of credit, because there’s a set repayment period.
This category of your credit score is called your credit mix. Lenders like to see a mix of both installment loans and revolving credit on your credit portfolio. So if you pay off a car loan and don’t have any other installment loans, you might actually see that your credit score dropped because you now have only revolving debt.
When you pay off debt, your credit score may drop for totally unrelated reasons. One common reason is new inquiries on your report. Every time you apply for new credit where the creditor runs a hard credit check, it’s listed on your credit report. It stays there for two years and may result in a temporary drop in your score. If you applied for a loan or a new credit card around the same time you paid off your debt, you may have unintentionally caused a drop despite your lower overall debt.
Tips for improving credit score after paying off debt
While paying off your credit card debt is important, what matters more is on-time payments and your utilization rate. Many times, borrowers will ignore these factors, thinking that clearing up their debt as quickly as possible is the key to a stellar score. But there are a few other methods to consider:
- Be strategic with the order in which you pay off your debts. Personal loans and credit cards often have higher interest rates than mortgages, car loans and student loans. Paying off those first not only helps keep your credit utilization in check, but will also save you money in interest. You can also use a debt paydown calculator to help decide what order it makes sense to tackle your debts.
- Check your credit utilization. If you’ve paid off your debt and your credit score went down, look at just how much of your credit you are using. If it’s above 30 percent, you might consider charging less each month. If that isn’t an option, you could speak with your issuer about increasing your credit limit. Both of those should help increase your credit score.
- Open another credit card. While opening accounts could temporarily lower your score due to hard credit checks, opening a new card could increase your total available credit and spread your charging among several cards.
Frequently asked questions
How long does it take for my credit score to update after paying off debt?
It can often take as long as one to two months for debt payment information to be reflected on your credit score. This has to do with both the timing of credit card and loan billing cycles and the monthly reporting process followed by lenders. However, the impact of the debt payment on your credit score may not necessarily be significant.
Does paying off collections improve your credit score?
Paying off an account in collections may or may not help your credit score. The impact depends on a variety of factors, including the credit-scoring model being used. Older credit-scoring models will reflect that a collection account has been paid and now has zero balance, which can positively impact your score, says Madison Block of American Consumer Credit Counseling. Newer credit-scoring models, however, will ignore the zero-balance status on a collections account.
The total number of accounts you have in collections also factors into your credit score. “If the collection event is recent and is the only one of its kind, then it may be advantageous to your score to resolve it,” says John Cabell, director of banking and payments intelligence for J.D. Power. However, if you have many debts in collections, then you may not see much improvement. Conversely, if the collection event is several years old, it may not actually be playing much of a role in your credit score anymore anyway.
Paying off debt is rarely the wrong decision, especially high-interest consumer debt. This holds true even if it causes your credit score to temporarily go down. Your financial health is more important than your credit score, especially because there’s no way to fully predict the results of each action you take. Ultimately, if you continue to make timely payments on your outstanding debts and keep your spending in check, you should see your credit score start to rise again with time.
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Original source: Bankrate