After what feels like forever, you finally pay off your debt. You know… that debt. Maybe it’s credit card debt that you’ve carried around for years. Perhaps it’s the student loans you never thought you’d get rid of. It could even be medical debt.
Whatever debt it is, you’ve paid it off and it’s gone – forever!
You feel relief, satisfaction, and a deep sense of personal accomplishment. Heck, yeah!
Until you notice that your credit score dropped. What in the world? Suddenly, you feel a rush of both adrenaline and disappointment. Why did my credit score drop after paying off my debt? Shouldn’t my credit score improve? What happened?
Unfortunately, this scenario is all too common.
It can cause even the most astute budgeters to question their tactics, strategies, and understanding of the financial system. But worst of all, it can discourage you from continuing the healthy budgeting techniques that you’ve put into place.
So that happened?
I Paid Off My Debt. Why Did My Credit Score Drop?
The length of your credit history constitutes approximately 15% of your credit score. The longer the age of the account, the stronger your credit.
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Lenders want to see that you are able to make your payments on time over a long period of time. The older your accounts, then the more history of on-time payments you have, which helps increase your score.
But when you pay off a debt, the average age of your accounts shrinks. Once the debt is paid off, then the account is closed. This results in a temporary drop in your account age.
Let’s take a look at a concrete example. Let’s say that you have four different types of outstanding debts:
- 15-year-old mortgage
- 10-year-old student loans
- 5-year-old medical debt
- 1-year-old car loan
In this specific scenario, let’s say that you are finally able to pay off your 15-year-old mortgage.
Prior to paying off your debt, the average age of your accounts was 7.75 years (15+10+5+1=31. 31 divided by 4 is 7.75).
But once you pay off your mortgage, that 15-year-old account is marked as closed. Those 15 years of on-time payments and good stewardship are no longer calculated into the “account age” portion of your score.
Suddenly the average age of your accounts drops to 5.33 years. That’s approximately a two-and-a-half-year difference!
Since the age of your accounts is 15% of your credit score, this is going to have a notable impact.
But that’s not all…
It’s not just the average age (or length) of your accounts. It’s also the different types of accounts that you have open.
Lenders and creditors want to know that you can handle different types of debt. There are two main types of accounts: revolving credit and installment loans.
Installment loans are where you borrow money in a lump sum and then pay that money back in fixed, scheduled payments (or “installments,” hence the name installment loans). Examples of installment loans are student loans and mortgages. Compare that to revolving credit, such as credit cards, where you can use your credit as needed on a revolving-door basis, as long as you pay it back. Credit cards and credit lines are the two most popular types of revolving credit.
If you pay off a debt, your credit score may temporarily drop because your “mix” of accounts has become less diversified.
Your “credit mix” accounts for 10% of your FICO score.
When combined together, your account age and credit mix are a total of 25% of your credit score, which is why the impact is so notable, even though you did a good thing by paying off your debt.
Does Paying Off Debt Early Hurt Credit Long-Term?
Nope! Only temporarily!
Think of it this way: by eliminating debt, you have created a new “baseline” for your finances. Give your FICO score a few months to re-calibrate, and your credit score will go back to normal. In reality, it might go even higher!
Here’s the important thing: your credit score is not more important than your budget.
Yes, we want to have a good credit score. Not only does it provide good peace of mind, but it also ensures that we get favorable terms the next time we need to take out a loan or apply for a line of credit.
But you shouldn’t avoid paying off debt because you’re afraid of hurting your credit score. It’s always best to pay off a debt if you can afford it.
Any drop will be temporary, and your budget will be healthier when you have more cash to apply towards your other debts, budget categories, or savings.
Why Did My Score Drop After Closing My Credit Card?
Since credit cards have higher interest rates than loans, let’s say that you decided to pay off your credit card debt.
Furthermore, in order to prevent the temptation of getting into consumer debt again, you decide to close your credit card account.
This could also cause your credit score to drop.
There’s another factor in your credit score called credit utilization. This is how much of your credit you are currently using. In general, it is recommended to keep your credit utilization below 30%. So if you have a $10,000 credit card limit, then you shouldn’t have more than $3,000 on your credit cards at the same time.
But if you pay off a credit card and close an account that was giving you a $5,000 line of credit, suddenly your utilization has increased to 60% from 30% ($3,000 used out of $5,000 vs. $3,000 used out of $10,000).
In short, there are three main reasons why your credit score could drop after paying off your debt:
- A change in the average age of your open accounts
- A change in the types or “mix” of credit that you have
- A change in your credit utilization
Again, it’s critical to understand that these are all temporary changes to your credit. It is always better to pay your debts than to miss payments or ignore them.
As long as you continue to make your payments on time, your credit score will recover from the temporary re-calibration and will likely improve!
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How to Pay Off Debt And Improve My Credit Score
Still, it is difficult to see your credit score drop, especially when you’ve been so intentional and diligent with your budget to get to a point where you can pay off your debt.
So how can you pay off what you owe without worrying about your credit score?
- Pay on time, every time. A history of late or missed payments will have a worse impact on your score than paying off your debt. Plus, late or missed payments are harder to recover from.
- Keep your credit cards open. If you’ve paid off consumer debt, you might want to close your credit card to prevent the temptation of getting into such debt again. However, it’s best to keep this account open to maintain your account age and prevent your credit utilization from going up. On the other hand, reasons to close your credit card might include expensive annual fees or poor customer service.
- Use reminders to pay bills. Auto-pay is a great way to make sure you never miss a bill. If you still prefer to do things manually or even by mailing in a check, then be sure to put reminders on your calendar.
- Watch for reporting errors. Not only will this help you detect potentially fraudulent activity, but it will also help you catch any reporting errors that are hurting your score.
- Avoid applying for more credit (unless you have to) in a short amount of time). Every time that you apply for credit, this counts as a “hard inquiry,” which results in a temporary drop in credit. The more times you apply, the more hard inquiries your score will have. Furthermore, multiple new open accounts will dramatically shorten the age of your accounts.
Debt and credit can be complicated subjects to understand.
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