At a Glance
Whether you’re paying off a personal loan or outstanding credit card debt, becoming debt-free can temporarily hurt your credit score. There are multiple reasons your credit score could drop after paying off debt, and while this seems counterintuitive, your score will rebound if you continue to manage other debt responsibly. Read on to learn more about:
Paying off debt may lead to a temporary score drop
There are multiple reasons paying off a personal loan or credit card debt can lead to a temporary drop in your credit score.
1. It was your only installment account
Installment loans are ones you pay off monthly, including mortgages, student loans, auto loans, and personal loans. Having a mix of different installment loans helps your score because it shows you’re a responsible borrower and can balance multiple debts. If you pay off your only installment account, your score may drop because you no longer have that mix of different types of accounts.
2. You may now have fewer types of credit
The types of accounts you have can affect your score because lenders want to see you’re responsibly using multiple different types of credit. In addition to installment accounts, you may have revolving accounts (credit cards). If you pay off and close the loan, your credit mix now has less variety, which can decrease your score temporarily.
3. Your average account age may have decreased
The length of your credit history accounts for about 15% of your credit score, so if you pay off your oldest account and close it, the average age of your accounts will decrease, which could lead to a drop in credit score. Note that closed accounts do stay on your credit report for seven to 10 years after you close them, but they are viewed differently than open accounts.
Over time, your average account age will increase again, so the decrease in score is likely short-term.
4. Reduced credit limit
This won’t always happen, but sometimes if you pay off a debt and your credit limit is reduced, it will increase your credit utilization which can decrease your score. In this case, you may need to reduce your credit card spending to improve your score.
5. Credit utilization may have increased
Credit utilization is the amount of credit available to you that you’re actually using. For example, if you have a credit card with a $2,000 limit and you’re only using $500 of that, you have a utilization rate of 25%. In most cases, lenders want to see that you’re using 30% or less of your available credit because it shows you can manage your finances without having to rely too heavily on credit.
However, if you pay off a credit card and close the account, the total amount of credit available to you will increase so your utilization may increase. This can lead to a drop in your score. Therefore, it can sometimes be smart to keep older accounts open, even if you don’t use them.
6. You closed a credit card
Closing a credit card can cause your score to drop for multiple reasons, including increasing your credit utilization and/or reducing your credit limit. If it was an older account, it can also hurt the average length of your credit history.
7. Late or missed payments
Payment history makes up 35% of your credit score and is in fact one of the most important factors in scoring models. In most cases, if a payment is more than 30 days late, it will be reported to the credit bureaus. The more you’re late, the more your score will decrease. And, depending on the lender or company, they may eventually report you to a collection agency, which can significantly decrease your score.
Other reasons your credit score could drop after paying off debt
1. You paid off an older collection account
While it seems smart to pay off a collections account, doing so with an old account can lead to the collection agency changing the date of the debt. The debt would then appear as a newer account on your credit report, so it would have a larger negative impact on your score.
2. Not enough time has passed since paying off debt
It may take one or two months before your score rebounds after paying off debt. This is because it depends on the timing of closing the debt and the billing cycles of the lender, as well as the monthly reporting process followed by lenders and the credit bureaus. Some credit bureaus may not get information about your debt for 30 or more days. Check your report to see if the account is marked as paid off, and if not, give it a little more time.
3. Your score drop is unrelated to paying off debt
There are other reasons you may see a decrease in your score that are completely unrelated to your debt:
i). Victim of identity theft
If someone steals your identity, they can use that to apply for and open credit accounts in your name, including credit cards and loans. Your score will decrease because of the hard inquiries, but if the fraudster doesn’t pay the bills, missed payments can get those accounts sent to collections which can damage your score significantly. They could also max out credit, increasing your credit utilization ratio.
The good news is you can help prevent this by placing fraud alerts on your credit profiles. You should also regularly monitor your credit score and reports for suspicious activity. If your identity is stolen, fill out an identity theft report with the FTC and start disputing the activity on your report. Also consider freezing your credit to make it more difficult for fraudsters to open accounts in your name.
ii). You’ve recently opened or applied for multiple lines of credit
If you apply for or open multiple credit accounts over a short period of time, whether installment or revolving accounts, you may be considered a higher risk to lenders. First, your score will drop due to having multiple hard credit inquiries on your report. You should only apply for credit cards or loans that you truly need and be sure to do research ahead of time, so you know which one is right for you before applying.
iii). Mistakes on your credit report
Sometimes lenders can make mistakes, which can lead to an inaccuracy in your credit report. It’s important to check your credit report regularly to watch out for errors, and if you find one, you can dispute it with the credit bureaus and the reporting lender. This can be done for free, and errors they find must be corrected promptly.
iv). Derogatory mark on your credit report
Having derogatory marks on your credit report typically means you didn’t pay a loan as agreed upon, whether it’s late or missed payments, an account in collections, filing bankruptcy, a lawsuit or judgment, a foreclosure, or a tax lien. The biggest downside to these derogatory marks is they typically stay on your credit report for seven to 10 years, so your credit score could be affected for many years.
If you see a derogatory mark on your credit report, make sure it’s legitimate. If not, you can dispute the error.
Shouldn’t paying off debt help my credit score?
Repaying debt is a required part of borrowing money, so it seems counterintuitive that paying it off can hurt your credit score. However, paying off debt can increase your credit utilization, lower the average age of your open accounts, and decrease the types of credit you have. If you close a credit card, you lose that account’s credit limit. These all can decrease your credit score even though you did what you were supposed to by paying off the debt.
However, most of the time these decreases are temporary. If you continue to make payments on other debt, your score will bounce back. You can adjust your spending to decrease your credit utilization, and as time goes on, your other accounts will age.
How credit scores are calculated?
You technically have multiple credit scores that can differ depending on the reporting agency (Equifax, Experian, FICO, TransUnion). FICO scores are the most widely used scores in the U.S. for consumer lending decisions, but even then, there are multiple FICO credit scoring models with slightly different algorithms used to calculate the score.
Typically, your FICO score takes five factors into consideration:
|Factor||Percentage of Score||Description|
|Payment history||35%||How often you make timely payments on your accounts. Late or missed payments, or defaulting on a loan, can drastically decrease your score.|
|Credit utilization||30%||The balance you carry divided by your total credit limit across all of your credit cards. Ideally, your utilization should be less than 30% of your available credit.|
|Length of credit history||15%||The average age of your account is important, and having older accounts can increase your score while new accounts can decrease it.|
|Credit mix||10%||Having a mix of installment loans (like mortgages, student loans, auto loans, and personal loans) and revolving credit (credit cards) can help show you are able to manage different types of debt and are a responsible borrower.|
|New credit||10%||Whenever you apply for new credit (including a loan) that triggers a hard credit inquiry, it stays on your credit report for two years.|
Tips for improving credit score after paying off debt
Paying off debt is important, and most drops in credit score that are a result of paying off debt are temporary. The most important things to improve your credit score are to continue to make your payments on time and keep your credit utilization rate low. This may require extra budgeting or adjusting your spending but doing so will have a positive effect on your score.
Other things you can do include:
- Pay off your debt strategically. For example, if you have debts with higher interest rates than others, paying off those first can help keep your credit utilization rate low and save you money in interest.
- Open another credit card. Opening a credit card can temporarily decrease your score by a few points, but it can also increase your total available credit and improve your credit mix.
- Be patient. This is hard, but if your score decreases because you paid off debt, it will bounce back over time if you continue to practice responsible habits.
How to keep your credit score from dropping?
The top ways to keep your credit score from decreasing are:
- Make payments on time. It can help to set up reminders to pay your bills or set up autopsy, so you never miss a payment.
- Monitor your score and credit report. Keep an eye out for inaccuracies and if you do see an error, report it.
- Avoid applying for multiple credit products in a short period of time. This will trigger multiple hard inquiries, which can result in drops in your score.
- Keep your credit utilization rate low. This may take additional budgeting but avoid accumulating large balances on your credit cards. Only spend what you need and pay your card off in full each month.
- Keep credit cards open. Unless you have a strong reason for closing them, such as an annual fee, you can keep the account open but just not use it. This will prevent your average account age or available credit from being affected.
One thing to avoid is keeping an installment account open just so it doesn’t decrease your score. This can quickly lead to missed payments, and you’re costing yourself unnecessary interest. If you’re able to pay off the loan, do so.
Typically, after paying off debt, your credit score will rebound after one to two months. This depends on the timing of closing the debt and the billing cycles, as well as the monthly reporting process followed by lenders and the credit bureaus.
While you may assume paying or settling a collections account will increase your score, it’s not always the case. Unfortunately, this item won’t be removed from your credit report so it can still affect your overall score. However, if there is a change in the information reported on the collection, or other information in the credit report, you may see your score increase slightly.
You should never apply for a loan if you don’t need one but taking out a loan can help improve your credit score because it increases your credit mix and helps your payment history (as long as you make payments on time). If you do this, be sure you don’t borrow more than you need, and you’re able to fit the monthly payments into your budget.