Your credit score is a reflection of how well you manage your debt, so paying off a large balance seems like it should automatically improve your score. Unfortunately, this may not always be the case, at least in the short term. If you’re wondering why your credit score goes down when you pay off debt, you have to dig a little deeper into all of the factors that impact your credit score.
Factors that impact your credit score
Your credit report contains a range of information on your financial history and all of those data points are used to create your credit score. One area that directly affects you after paying off debt is your credit utilization. This ratio measures how much credit you’re allowed by your creditors versus how much of a balance you carry.
Your credit utilization may cause your score to suffer. That’s because this category includes other your credit utilization ratio for each credit card as well as your overall balances. Ideally, your balances should be no more than 30% 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, that can make your overall utilization higher. Consequently, your score could drop.
Another reason your credit score could decrease is if you pay off an installment loan but still carry credit card debt. 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. While you may wonder how many points your credit score goes up when you pay off a car loan, for example, you might actually see that number drop since having revolving credit without any installment loans can hurt your credit.
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 results in a slight drop for one year. 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 debt.
How long does it take for my credit score to update after paying off debts?
Your credit score doesn’t update automatically, so it can take some time before you see whether paying off your debt helped or hurt your score. Expect to wait at least one to two billing cycles from your credit card before seeing your updated balance appear on your credit report.
Here’s something to remember: Paying off your entire balance every month is not reflected in your utilization rate or, ultimately, your credit score. The balance that is used to calculate your utilization rate is based on your last statement balance. So, you could charge $900 on a credit card with a $1,000 limit and pay it off the same month, but the FICO credit score will still consider a utilization rate of 90%.
How do I keep my credit score from dropping?
While paying off your credit card debt is important, what matters more is on-time payments and 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.
Also 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 those off first not only helps keep your credit utilization in check, it could also save you money in interest.
When you’ve paid off your debt and the credit score has decreased, look to just how much of your credit you are using. If it’s above 30%, you might consider charging less each month. If that isn’t an option, you could speak with your issuer about increasing your credit limit.
You also could open another credit card to increase your total available credit and spread your charging among several cards, but your credit will initially take a hit when applying for the credit card. That ding will lessen over time and disappear altogether after two years.
The bottom line
Paying off certain types of debt may not have the impact you expect in terms of increasing your credit score. But that doesn’t mean it’s a bad idea. 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.
Instead, compare your debts and come up with the pros and cons of paying off each one, especially if you can save money on high interest rates.
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