Managing Money In A Crisis
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Why did my credit score drop after paying off debt?
Reasons your score took a hit — and how you can build it up again.
Paying off a large debt may be a huge milestone, but your score likely won’t reflect it — at least not at first. Your credit is calculated based on more than just closed accounts. So while your credit history may look favorable to lenders when you pay off debt, your credit score may actually take a hit.
Why did my credit score drop after I paid off my debt?
Your credit score is based on several factors that are all impacted when you pay off debt. A shift in your credit utilization ratio, credit mix or length of credit history may all be part of why your score dropped.
Credit utilization
Your credit utilization ratio is the amount of credit you are currently using compared to the amount of credit you have available. The general rule is to have a credit utilization ratio under 30%.
When you pay off a loan but still carry balances on your credit cards, your credit utilization ratio can shift. If it jumps above 30% — or to 0%, if you didn’t have many other accounts in use — your credit score may dip.
Credit history
The age of your accounts, both individually and on the whole, can also play a role in your lowered score. If you paid off your student loan after 10 years and are left with newer accounts, your credit history will be shorter. And while your previous accounts will still show up on your credit report for up to seven years, they’re no longer considered when your score gets calculated.
Credit mix
The types of accounts you have open will also impact your score. For example, if you pay off your car loan and are only left with high-interest credit card debt, your credit mix won’t be as diverse.
Having a variety of debts — like mortgages, car loans, personal loans and credit cards — helps create a better credit mix. But this mix of credit accounts makes up a relatively small portion of your score.
Can I prevent my credit score from decreasing?
Depending on your current credit mix, you may not see your score drop at all when you pay off debt. To help prevent it, follow these quick tips:
- Avoid new accounts. It may be tempting to open a new account right before paying off your current debt to increase your credit utilization ratio or credit mix, but try to postpone it as long as possible. Hard inquiries on your account will lower your score, which can easily compound the problem.
- Pay off debts strategically. Focus on high-interest debt like credit cards and personal loans first. Student loans, car loans and mortgages typically have lower rates and longer terms, making them a relatively stable way to keep your credit utilization balanced.
- Look for errors. You’re entitled to a free credit report from each of the three major credit bureaus every 12 months. Check for errors and dispute any you find — it can be a simple way to increase your score after paying off debt.
- Keep up with payments. Payment history is one of the biggest factors in your credit score. Set up reminders and use automatic payments when possible. The more payments you have under your belt, the better your credit score will be.
- Don’t close your accounts. Once you pay off a loan, you won’t have a choice — your account is closed. But if you’re focusing on paying off your credit cards, consider keeping your accounts open. This will help contribute to your credit mix and credit utilization ratio, which could keep your score intact.
Will my credit score eventually improve?
Yes, but it will take some time. As you continue making on-time repayments and opening new accounts, your credit score will shift. A few points won’t make much of a difference as long as you avoid missing payments and defaulting.
The big benefit to paying off your debt is the way it looks on your credit report. Lenders will see you know how to handle debt, which may improve your chances of approval for future loans and credit cards — even if your score is slightly lower.
But remember that closed accounts will eventually drop off your credit report. To maintain and improve your score, try to keep a good balance of debt and available credit throughout your life. This will help set the stage for low rates for years to come.
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Bottom line
A dip in your credit score is no reason to avoid paying off your debt. In fact, there are tactics you can use to improve your credit so closing an account won’t have as much of an impact. Just stay patient: Your score will recover, and having an account paid off proves to lenders that you’re responsible with your debt.
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