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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.
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.
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.
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.