When you pay off debt, it seems like a given that your credit score will go up. After all, credit scores are supposed to show your ability to manage debt responsibly.
But sometimes the opposite happens. When you pay off debt, you may actually see your credit score fall in the short term. Here’s why you may see a temporary drop in your credit score in the months after you pay off debt — and why you shouldn’t worry about it too much.
4 Reasons Your Credit Score Drops After You Pay Off Debt
A credit score is a mysterious three-digit number that’s generated by an algorithm based on the information in your credit reports. Your score predicts how likely you are to repay debt. But sometimes credit score math defies logic. Here are four reasons your credit score can drop after you pay off debt.
1. You Reduced Your Overall Credit Limit
Paying off credit cards before other debts is almost always a savvy move. Credit cards are typically your highest-interest type of debt.
Paying them down reduces your credit utilization ratio, which is the percentage of open credit you’re using. It determines 30% of your FICO score. But if you close old credit cards after you pay them off, you’ll increase your credit utilization, so your score is likely to fall. (Paying off a loan or a mortgage doesn’t lower your credit utilization.)
So unless the card carries an exorbitant fee, you’ll want to keep it open.
After you pay off a credit card balance, be sure to use the card at least once every three months. Otherwise your card may be canceled for inactivity.
2. You Lowered Your Credit Age
Scoring models like to see that you can handle a long-term relationship with credit. Your average age of credit accounts for 15% of your credit score. If you paid off a loan or closed a credit card and it was one of your older accounts, your credit age will drop, which could tank your score.
That certainly doesn’t mean you should avoid paying off a loan just to keep the account open. But if you’re getting ready to pay off a loan, be prepared for a temporary drop in your score.
3. Your Credit Mix Changed
Having a mix of credit cards and installment loans, like a car loan or mortgage, is viewed positively in the world of credit scores. Your credit mix determines 10% of your score in FICO’s model, meaning it has a relatively minor impact.
However, if you pay off your student loan or car loan leaving only your credit cards as open accounts, your credit mix will change. If your credit score drops by a few points, a change in your credit mix could be the culprit.
4. Another Factor Is to Blame
Credit score fluctuations are completely normal. If your score goes up or down by just a few points, it’s difficult to attribute the change to any one factor. But if you’ve seen a substantial drop, check your credit reports at AnnualCreditReport.com to make sure everything is accurate. About 1 in 5 reports contain inaccurate information.
Some other possible explanations for why your score dropped after paying off debt:
- You made late payments on another account. Your payment history is the most important credit factor, accounting for 35% of your score. A late payment will stay on your credit report for seven years, though the damage has the most impact on your score in the first two.
- You increased the balance on another account. If you paid off one credit or loan balance but you increased the balance on another, your credit utilization may have increased, which would cause your score to drop.
- You opened new credit. Opening new credit typically drops your credit score in the short term because you lower your average credit age, plus you get a hard inquiry on your credit report.
Should You Care if Your Credit Score Drops?
Any dip in your score will probably be temporary. Most people see their scores recover within a few months.
Even though it’s frustrating to see your score drop, keep in mind that lenders consider a lot of factors in determining whether to approve you for credit and how much interest you’ll pay. One important consideration is your debt-to-income ratio, which will probably be lower after you pay off debt. But if you’re planning a major purchase, it could be worth waiting a few months until your score bounces back.
The bottom line: Never hang onto debt just because you’re worried about the impact on your credit score. Paying off debt is a good thing, regardless of what your credit score says.
Robin Hartill is a certified financial planner and a senior writer at Codetic. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected]