Key takeaways
- If you take out a loan to consolidate debt, you could see a temporary drop in your credit score due to the hard inquiry for the new loan.
- Your credit score can take 30 to 60 days to improve after paying off revolving debt.
- Your score could also drop because of changes to your credit mix and the age of the accounts you leave open.
- Paying off debt and avoiding new credit benefits your financial health enough to outweigh any temporary dips in your credit score.
Your credit score may drop after you pay off debt because the credit scoring system factors in things like your average account age and credit mix. If you applied for a loan to consolidate debt, the lender’s hard credit inquiry can also ding your score. The dip may be disappointing, but in most cases, it’s a temporary drop that can be recovered in a few months.
However, the types of debts you clear out and how you pay them off can cause a permanent drop if you don’t understand the factors impacting your credit score. It is important to understand how they work and continue engaging in good money management, which you can do without taking on additional revolving debt if you choose. These steps can help you maintain a good credit score and get the best terms on money you borrow in the future.
Why credit scores can drop after paying off a loan
There are many reasons why a credit score drops after paying off debt. Most are related to the type of debt you pay off, how you pay it off and whether you keep the account open. The credit scoring system weighs many different factors when you pay off debt. Some impact how much your score drops more than others. Different models look at similar factors but can vary in how they are weighed. We’ll focus on the FICO credit scoring model, the most popular among lenders.
You missed a payment before your debt was consolidated
Payment history makes up 35 percent of your credit score under the FICO model. A missed payment can tank your score faster than anything else. Whether you’ve been approved for a debt consolidation loan or a cash-out refinance on your home, don’t rely on the lender to make on-time payments.
Even if the lender offers to pay the creditors directly, check with your creditors to ensure it actually happened. You’re still responsible for the payments, and your credit score will suffer if they’re late. If you end up paying a few dollars more than you owe, the creditor will refund you.
You accidentally increased your overall credit utilization
This can happen if you pay off multiple credit cards and close them out but leave balances on other smaller cards. Your credit utilization ratio measures how much total available credit you use and makes up 30 percent of your score. The lower the ratio, the better it is for your score. As a rule, your credit utilization ratio should stay under 30 percent to avoid hurting your score.
When you close out credit cards, you reduce your available credit. Even if your remaining balance is small, your credit score could take a hit if it raises your utilization ratio above the 30 percent threshold.
Here’s an example of how this could happen.
- You have four credit cards totaling $10,00 of available credit.
- You have $2,750 of credit card debt across three of the credit cards and $250 on the fourth.
- You take out a debt consolidation loan to pay off the $2,750 debt.
- You close out the three cards tied to the $2,750 balance you’re paying off, but those cards totaled in $9,500 of available credit.
- You only keep open a $500 credit card — the one with a $250 balance on the monthly statement.
On the surface, this looks like a great plan. You just converted $2,750 worth of debt into an installment loan and eliminated the temptation to use the other $7,000 in the future. But there’s a problem. Previously, you had $3,000 in total outstanding balances out of $10,000 available. Divide $3,000 by $10,000 and you’ll find you had a 30 percent credit utilization ratio before paying off your debt.
You now have only $500 in available credit. With a balance of $250, 50 percent of it is in use — compared to just 30 percent before. Despite all the revolving debt you paid off, your credit score will drop because of the spike in your credit utilization on the credit you have left. This is why we recommend against canceling credit cards you’ve paid off, even if you don’t plan to use them again.
You’ve lowered the average age of your accounts
Closing out accounts you’ve had for a long time — even if you haven’t recently used them — can lower your score. The length of your credit history accounts for 15 percent of your credit score. A sudden change in the average age of your open credit accounts could make your score fall.
You paid off your only installment loan or revolving debt
Creditors like to see that you can manage a mix of installment debts like loans and revolving debts like credit cards. For example, if you paid off your only personal loan and don’t have other installment loans (like a car loan), that could cause a small dip.
But don’t let this prevent you from paying off debt. Credit mix only makes up 10 percent of your score. You can build good credit by focusing on optimizing the other factors rather than taking on or keeping debt you don’t need.
You took out a new loan to pay off other debt
Credit bureaus look at new inquiries on your credit. If you apply for a debt consolidation loan to pay off other credit accounts, your credit score could drop a few points. This temporary blip will usually correct itself a month or two after the hard inquiry.
How long does it take for your credit score to improve after paying off debt?
It can take months to years to increase your credit score after you pay off debt, depending on why the score dropped. After paying off revolving debt, your score typically recovers in a few months. Key factors that affect how long it takes for your credit score to go up after paying off debt include whether you leave cards open, stay under a 30 percent utilization ratio and keep up with payments. After a drop due to a credit inquiry, your score should recover in a month or two as long as you avoid any new credit inquiries.
Drops related to late payments, credit mix and length of credit score take more time to improve. Your payment history will gradually boost your score as you make future payments on time. The credit mix score will improve as you open a variety of different installment and revolving accounts. The length of your credit history increases the longer you keep accounts open.
5 ways to increase your credit score after paying off a loan
To increase your score after paying off a debt, you must know how that debt affected your overall score.
1. Pay everything on time
Consider setting up automatic payments on any credit you have to avoid missed payments. Learn the grace periods on your accounts, and never rely on a lender to pay your debts off, even if they’re being paid through a debt consolidation.
2. Keep your credit utilization ratio low
Your credit utilization ratio is calculated by dividing the balances you carry by your total credit limit across all your cards. Spending no more than 30 percent of your available credit can keep this ratio low and lift your credit score.
3. Avoid closing out older credit accounts
Keep at least one or two older credit accounts open, even if you never use them. This shows the lender that you’ve been able to manage credit longer. It shows you’re likely to do the same with new accounts in the future.
4. Limit new credit inquiries
Even if you’re shopping for the best rate to consolidate your credit, too many hard inquiries tell the credit scoring model you may be opening many new credit accounts. Prioritize lenders that offer prequalification without a hard inquiry. And keep your applications with lenders that require a hard inquiry to a 14-day window to minimize the credit score impact.
5. Optional: Diversify your credit portfolio
Lenders want to see if you can handle regular fixed payments like installment loans and revolving credit like credit cards. Installment debt requires discipline to budget for the amount every month while revolving credit requires you to keep track of how much available credit you use.
If you can manage both well, you’ll see an improvement in the credit mix portion of your credit score. However, as this makes up only 10 percent of your credit score, do not feel the need to take on unnecessary debt just to improve your credit score. Keeping your overall finances healthy is more beneficial in the long run.
The bottom line
Ultimately, paying off debt is a healthy financial decision, even if it leads to a slight drop in your credit score. Most of the drops are temporary, but it’s important to understand some factors that could have a greater and longer-lasting negative impact on your credit scores. Keeping your payments current, using different credit types and keeping your credit utilization low are the best ways to preserve your credit score.
Frequently asked questions
Read the full article here