Why does my credit score go down after paying off debt?

Why Does Paying Off Debt Sometimes Hurt My Credit Score?

While paying off debt is undeniably a positive financial move, it’s sometimes counterintuitive: closing a loan account can temporarily lower your credit score. This isn’t a sign of mismanagement; it’s a byproduct of how credit scoring works. Understanding the mechanics behind this phenomenon can help you navigate these situations more effectively.

The primary reason for this dip lies in the intricate algorithms used to calculate credit scores. These algorithms consider several factors, and closing a loan account impacts two crucial ones: available credit and credit history length.

Reduced Available Credit: Your credit utilization ratio, a key component of your credit score, is calculated by dividing your outstanding credit card balances by your total available credit. When you pay off a loan, you reduce the total available credit. This, in turn, can elevate your utilization ratio, even if your other balances remain unchanged. A higher utilization ratio, even if still below the ideal 30%, can temporarily lower your score.

Shrinking Credit History: Credit history length is another important factor. A longer credit history generally signals greater financial responsibility and stability to lenders. Closing a loan account shortens the overall time span of your credit history. This reduction, while insignificant in the grand scheme of a lengthy credit journey, can sometimes contribute to a temporary dip in your score.

The Importance of Account Diversity: Maintaining a diverse range of accounts, including different types of credit like credit cards, installment loans, and mortgages, is beneficial. This diversity demonstrates your ability to manage various types of debt. Closing a loan account, especially if it’s the only installment loan you have, can slightly alter this balance, potentially impacting your score in the short term.

Beyond the Numbers: While a temporary dip is possible, the long-term benefits of debt repayment usually outweigh the short-term score fluctuation. Closing a loan often signifies responsible financial management, a positive aspect that, over time, will greatly improve your creditworthiness.

What to Do?

While you can’t prevent a potential temporary dip, proactively monitoring your credit score and understanding these dynamics can help you anticipate any short-term fluctuations. Don’t be discouraged if you see a slight decrease; focus on maintaining good financial habits, and your score will improve over time. Ideally, you want to keep diverse account types, even if you pay off one loan. If possible, try to keep accounts open even if you no longer need them or use them frequently, as long as there are no fees associated with keeping the accounts open.