If you have just paid off your debt or cleared your credit card balances, you might believe that you’ve done something good for your credit score. But credit scores can drop when people pay off their debts. This must be confusing for most Americans who want to clear their debts to improve their financial health.
The whole point of paying off a loan or credit card is to improve your credit score. After all the trouble you must have gone through to pay off your debt, it would be shocking to find that your credit score has, in fact, gone down. So it’s natural to wonder, “Why did my credit score drop after paying off debt?”
To find out why credit scores take a temporary dip once people pay off their debts, we must first understand the concept of a credit score. Although most people are aware of credit scores and their importance, few know what goes into calculating a credit score.
What is a credit score?
Most of the credit score queries sent to the editorial team at MoneyWizard are from people who are in the market for mortgages or other loans. They believe that credit scores are an accurate representation of their credit histories. But your credit score isn’t the whole picture. It’s an indicator of your current bandwidth to handle credit.
In other words, your credit score is a measure of your ability to pay back what you owe. It’s calculated after taking into account the following factors:
- Your payment history
- Your current debt balances
- The length of your credit history
- New lines of credit you’ve applied for
- Your overall credit mix
These factors don’t have the same weight in the computation of your score. The first two, your payment history and current total debt, account for around 65% of your credit score, according to the personal finance experts at MoneyWizard.
Why your score dropped after paying off debt
There are several reasons why your credit score could drop after you clear your debts or loans. The act of paying off debts may affect one or more of the components that make up your credit score, so it’s vital to understand what actions can trigger the dip.
Change in credit age
One of the factors affecting your credit score is your credit age. The algorithms that determine credit scores like it when you have a higher credit age. Unfortunately, when you pay off debt, you end up lowering it temporarily. This is important because your credit age accounts for 15% of your overall credit score.
Paying off your credit card balances does sound good. If it’s a loan that you’ve been paying for years, it would certainly be a relief to finally settle it. But you are also ending one of your longer credit relationships when you do that. This lowers your credit age and negatively impacts your credit score.
Does this mean that you shouldn’t clear your debt just because it’s a credit card that you’ve been using for years? Certainly not. But you should be prepared for the dip in your credit score that may immediately follow it.
Change in credit utilization rate
If there’s one thing that the editorial team at MoneyWizard has repeatedly reminded our readers, it’s the need to pay off credit card balances as early as possible. The biggest reason for this is the high interest and additional fees that accumulate for unpaid balances.
Your credit utilization also impacts your credit score. When you max out all your credit cards, you’ll get a lower credit score. So it’s better to keep your credit utilization rate, defined as the proportion of available credit that you’re using, low.
Credit utilization also affects your score because when you pay off your credit card balances, you end up increasing your credit utilization rate. It’s important to note that this doesn’t apply when you pay off mortgages or loans.
Change in credit mix
There are two types of credit that you usually have. The first is installment credit, like mortgages or car loans. These come with a fixed timeframe for repayment. The second type includes your credit card balances and other lines of credit that don’t have a fixed repayment period. These are called revolving credit.
What you want in your overall credit is a balance of installment and revolving credit. When you settle a car loan or pay off a mortgage, the balance skews toward the credit available to you on your cards, which will lead to a dip in your credit score.
How to rebound
Keep accounts active and open
It pays to keep your credit card accounts active and open. Closing them could trigger a drop in your credit score because you’re reducing your credit age and available credit. Even after you pay off your credit card balances, it makes sense to use your card once a month or so to keep it active.
Maintain less than 30% credit utilization
When you pay off debt, ensure that your credit utilization doesn’t exceed 30%. The first option is to utilize less each month. But in case you need more credit, negotiate with your bank to increase the total credit available to you and keep your credit utilization under control.
Always pay on time
Regular readers of MoneyWizard will be familiar with this. For your financial security and well-being, you should always pay on time. This means you should limit what you have to pay by cutting down on needless expenses. The key is to make a budget, calculate how much you spend on impulse purchases, and ruthlessly minimize them.
A temporary hit to your score is no reason to avoid tackling debt
While paying off debt can negatively impact credit scores, what you’ve got to remember is that it’s temporary. The short-term dip shouldn’t discourage you from being financially prudent. You should pay off all credit card balances and debt that you can. This will improve your credit score in the long run, ensuring your financial health and stability.