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.
Your credit score is determined by more than just debt. Your credit utilization ratio and average age of debt — among other factors — influence your credit score. Understand the factors that impact your credit score and how you can keep your score in good standing even after paying off debt.
Get pre-qualified
Answer a few questions to see which personal loans you pre-qualify for. The process is quick and easy, and it will not impact your credit score.
Get Started
What factors impact your credit score?
Although it varies by credit scoring model, these are the general factors that affect your FICO score.
- Payment history. Payment history is the most crucial factor — it accounts for 35% of your credit score. As a result, it’s important that you pay all of your bills on time. If you don’t, lenders can report your late payments to the credit bureaus, which can cause serious harm to your credit.
- Credit usage. Your credit utilization ratio — how much of your available credit you use — accounts for 30 percent of your credit score. Using a high percentage of your available credit can lower your score.
- Length of credit history. How long your credit accounts have been open plays a minor role — it makes up 15 percent of your score. Factors that are considered include the average age of all of your accounts, the age of your oldest account the age of your newest accounts.
- Credit mix. Having a diverse mix of credit accounts — for example, an auto loan and mortgage, may help improve your score. These categories account for 10 percent of your credit score.
- New credit. How many times you’ve recently opened new credit accounts and applied for them also makes up 10 percent of your score.
Why credit scores can drop after paying off a loan
Credit scores are calculated using a specific formula and indicate how likely you are to pay back a loan on time. But while paying off debt is a good thing, it may lower your credit score if it changes your credit mix, credit utilization or average account age.
You eliminated your only installment loan or revolving debt
Creditors like to see that you’re able to manage various types of debt. Ideally, your debts should be a mix of installment debts like loans and revolving debts like credit cards. 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 results in a better score. You should try to only use 30 percent of your total credit across all debts. When you pay off a revolving line of credit or credit card in its entirety and close the account, 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.
How long does it take for your credit score to improve after paying off debt?
The short answer: it depends on many factors. “Although paying off debt may boost your credit score, the time it takes for your score to reflect these changes varies,” according to Dr. Enoch Omololu, a personal finance expert and founder of Snappy Rates. Since lenders usually only report payments once a month, you may not see an impact on your score until after the next reporting cycle, so in 30 to 60 days.
This is a continual process, says Beverly Harzog, a credit card expert and author of The Debt Escape Plan. “While paying down your credit cards may raise your score, it only works if you don’t take on new debt.”
What to do to increase your credit score after paying off a loan
FICO scores are determined by five categories: 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).
To increase your score after paying off a debt, you will need to know how that debt played into your overall score.
Maintain a positive payment history
Your credit score is heavily influenced by how often you make on-time payments on your accounts. Missing payments or defaulting on loans will quickly tank your score.
Paying off your debt shouldn’t affect this aspect of your credit score. But 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. It’s better to pay off a debt and take a small hit to your score than to purposefully avoid closing an account. That will only cause more financial strain in the end.
Diversify your credit portfolio
Installment loans (like car loans, student loans and mortgages) have a set repayment period. Credit card debt is considered revolving debt since the total amount of debt changes from month to month. Installment loans don’t impact your score as heavily as revolving debts like credit cards and lines of credit because of the 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.
Reduce your credit utilization ratio
Your credit utilization ratio is calculated by dividing the balances you carry by your total credit limit across all of your cards. Having small balances will help keep your credit utilization ratio in the sweet spot between 10 percent and 30 percent. You can charge less each month or request a credit limit increase. Both should help improve your credit score.
Apply for new credit
When you close a loan or pay off a credit card, taking on new debt may actually improve your credit score. As long as it increases your total pool of credit — which decreases your total credit utilization ratio — or diversifies your portfolio, new debt could increase your credit score. However, applying for another loan won’t help if the debt you had was older. A new account won’t bring you any wins with credit history length.
Next steps
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.
Frequently asked questions
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,” said 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.
[/su_br_article_accordion_wrapper]
Sure, let's break down the concepts mentioned in the article:
-
Credit Score Factors:
- Payment History (35%): Timely payments are crucial. Late payments reported by lenders harm your credit.
- Credit Usage (30%): How much of your available credit you use affects your score. Keeping it low is beneficial.
- Length of Credit History (15%): The average age of accounts matters. Longer-standing accounts indicate stability.
- Credit Mix (10%): Having varied credit types, like loans and credit cards, can be beneficial.
- New Credit (10%): Opening new accounts impacts your score. Too many new accounts in a short period can be negative.
-
Impact of Paying Off Debt on Credit Score:
- Change in Credit Mix: Eliminating a certain type of debt may make your credit report less diverse, impacting your score.
- Increased Credit Utilization: Paying off and closing an account decreases available credit, raising utilization rates.
- Lowered Average Account Age: Closing older accounts reduces the average age of your accounts, which can affect your score negatively.
-
Timeline for Credit Score Improvement After Paying Off Debt:
- Usually, it takes 30 to 60 days for changes to reflect in your credit score, as lenders report payments monthly.
-
Actions to Increase Credit Score After Paying Off Debt:
- Maintain Payment History: Timely payments are crucial for a good score.
- Diversify Credit Portfolio: A mix of installment loans and revolving credit is beneficial.
- Reduce Credit Utilization Ratio: Aim for a ratio between 10% and 30% by managing balances.
- Consider New Credit: Taking on new debt might help by diversifying or increasing total available credit.
-
Advice on Paying Off Debt and Credit Scores:
- Paying off debt is beneficial for financial health, even if it causes a temporary dip in credit scores.
- Continued timely payments and responsible financial behavior should gradually improve the credit score over time.
-
FAQs on Debt and Credit Score:
- Paying off collections can impact the credit score, but the effect varies based on the credit-scoring model and the age/number of collection accounts.
Understanding these concepts helps manage the impact of paying off debt on credit scores and strategies to improve or maintain a good credit standing.
