MORE LIKE THISPersonal Finance
Making a final debt payment can feel freeing, but it won’t necessarily bump up your credit score. Worse, it can actually cause a dip in your score, as counterintuitive as that may be.
To know why, it’s important to understand the factors that make up your credit score.
Why would my credit score drop after paying off debt?
To be sure, creditors want you to repay them when they lend you money, so it seems reasonable that paying off debt would help your credit score. But that's not exactly how credit formulas work.
Credit utilization — the portion of your credit limits that you are currently using — is a significant factor in credit scores. It is one reason your credit score could drop a little after you pay off debt, particularly if you close the account. Having low credit utilization (30% or less, and the lower the better) is good.
Other factors that credit-scoring formulas take into account could also be responsible for a drop:
The average age of all your open accounts. The most commonly used score, FICO, continues to include the age of your closed accounts in its scores. But rival VantageScore may not. If you paid off a car loan, mortgage or other loan and closed it out, that could reduce your age of accounts in VantageScore's calculations. That's also true if you paid off a credit card account and closed it.
The types, or "mix," of credit you have. Scores reward you for having both installment accounts (with set payments over a specific time, like a loan) and revolving accounts (with varying payments and no set end date, such as credit cards).
Let's say you just made the final payment on your car loan. Your payment history is perfect and you keep credit card balances low. But now you have one less account, and if all your remaining open accounts are credit cards, that hurts your credit mix. You may see a score dip — even though you did exactly what you agreed to do by paying off the loan.
The same is true of credit cards. Usually, paying off a credit card helps lower your credit utilization because your remaining balances are a smaller percentage of your overall credit limit. But if you close the account you just paid off, you lose that account's credit limit and now your other balances represent a greater percentage of your total limit.
It's smart to keep on top of the factors that influence your credit score, and it's easy to automate. NerdWallet can show you where you stand with credit score factors and how your score is responding. NerdWallet updates your credit information weekly.
Get score change notifications
See your free score anytime, get notified when it changes, and build it with personalized insights.
How to pay off debt and help your credit score
Focusing on credit card debt first can help your budget because cards tend to have higher interest rates than installment loans. It also helps your score by lowering your credit utilization.
Credit utilization is calculated both on a per-card and overall basis. If you have any credit cards that are anywhere close to their limits, make it a priority to lower those balances to no more than 30% of your limit — and lower is better.
Keep these credit-building habits in mind:
Pay on time, every time. Late payments can seriously damage credit.
Keep credit cards open unless you have a compelling reason for closing them, such as an annual fee or poor customer service. When you close an account, it can reduce your average account age. It also cuts your available credit, which sends utilization up.
Use credit lightly. If you no longer love the card, consider putting a small, recurring charge on it, and putting it on autopay. That way you don't miss paying the bill, and the issuer won’t close the card because of inactivity.
Take an overall view of installment loans. Don't keep an installment loan open just to avoid score damage — you're costing yourself unnecessary interest.
How do I keep my credit score from dropping?
Once you’ve gotten your balances to zero, here’s how to guard your credit.
Make it easier to pay on time. Set up reminders to pay bills. You can set up calendar reminders, or get emails or text alerts from most issuers.
Watch for credit report errors. Any attempt to build your credit will be fruitless if the data going into your scores is wrong.
You can get free credit report information two ways: Some personal finance websites and credit card issuers offer report information. And you’re entitled to a free report directly from the credit bureaus.
The reports you can get weekly from the three credit bureaus can run to dozens of pages.
If you see an error, dispute it. Someone else’s file mixed up with yours or identity theft could potentially — and unfairly — hurt your score. The sooner you address that, the better.
Don’t apply for multiple credit products in a short time. Opening a new credit account lowers the average age of your credit accounts and involves a hard inquiry, which can result in a small, temporary drop in your score. If you can, wait at least six months between credit applications, and do your credit card research before you apply.
Practice patience. Sometimes the best thing you can do for your credit is wait. A combination of patience and good habits will help any credit score bounce back. Most credit missteps fall off your credit records in seven years.
» MORE: Use NerdWallet's free credit score simulator to learn how money moves could affect your credit — and get your free score, too.
You know, there's something about diving into the intricacies of personal finance that really gets me going. It's like navigating a complex puzzle where every move affects the big picture. Now, let's dissect this article.
First off, paying off debt can be a double-edged sword when it comes to credit scores. Credit utilization, the ratio of your current credit usage to your credit limits, plays a crucial role. If you close an account after paying off debt, it can reduce your available credit and increase your overall credit utilization, potentially causing a dip in your credit score.
Now, let's talk about the factors that influence credit scores. The average age of all your open accounts matters. The FICO score considers the age of closed accounts, while VantageScore may not. Closing accounts, be it a car loan, mortgage, or credit card, can impact your credit score by reducing the average age of your accounts.
The types of credit you have, known as your credit mix, also play a role. Credit scores favor a mix of installment accounts (like loans with fixed payments) and revolving accounts (such as credit cards with varying payments). Paying off a car loan or closing a credit card account may negatively affect your credit mix.
Now, onto some credit-building habits mentioned in the article. Paying on time is a no-brainer; late payments can wreak havoc on your credit. Keeping credit cards open, unless there's a compelling reason to close them, is advised. Closing accounts can reduce your average account age and available credit, impacting your credit utilization.
Another tip is to use credit lightly. If you're not a fan of a credit card anymore, consider putting a small, recurring charge on it to keep it active. But, and here's the kicker, make sure to pay it off promptly.
Finally, how to prevent your credit score from dropping further. Set up reminders to pay bills on time, check your credit report for errors regularly, and dispute any inaccuracies. Avoid applying for multiple credit products in a short time, as it can lower the average age of your credit accounts and result in a temporary score drop. And lastly, practice patience—credit missteps typically fade away after seven years.
In essence, managing your credit is like a delicate dance, and understanding the nuances can help you navigate the financial landscape more effectively.
