Why Can Paying Off Debt Lower My Credit Score?

This is a tricky question. On the one hand, paying off debt is generally good for your credit score. We all know that.

But if you've ever seen a small dip in your credit score after paying off debt, here's a quick explainer about what might be happening.

To start, it helps to know a little more about how your credit score is calculated. According to the three major credit-reporting bureaus, the types of credit accounts you have open can make up either approximately 10% or 15% of your score.

More specifically, the impact on your score can partly depend on what kind of debt you’re paying off.

Installment loans such as mortgages, auto loans or student loans can positively impact your score if you pay them on time because they help to diversify your credit.

So let's assume you just paid off your car loan. That's great. But once you pay off that installment loan, it becomes a closed account and that may also leave you with a less diverse mix of credit accounts.

And that could temporarily lower your score.

The complex algorithms used to calculate credit scores make it nearly impossible to predict the exact amount your score might fall after you pay off a card or loan.

The score may drop by a lot or only a little depending on a myriad of factors that are unique to your credit and payment history. The good news is that scores typically rebound from a debt payoff in about a month or two, as long as you keep paying your other creditors on time.

So, paying off debt is definitely in your best interest – both for now and the long run. Instead of worrying about how paying off one loan might temporarily lower your score, it’s better to think of your credit score as a marathon, rather than a sprint.

Here’s a breakdown of some factors that generally affect your credit score.

Steady payment history

• A steady record of on-time payments throughout the life of a loan will positively affect your credit score over time. According to FICO, payment history accounts for 35% of your credit score.

Credit utilization ratio

• This is the total amount of credit you’re using divided by the total amount of credit you have available. The number is based only on accounts with revolving credit.
• Paying off your credit card debt in full every month is good practice. Typically, a low credit utilization rate of 30% or less is considered good.

Other factors: credit history, credit mix, new credit

• If you do want to close out a credit card, choose one that you haven’t had as long. The length of your credit history matters.
• Some credit scoring models take into account your credit mix, or the range of credit accounts that comprise your score.
• If you’re shopping for a new credit card or personal loan, keep in mind that financial institutions do a hard credit check when you apply. Too many credit checks within a short amount of time can lower your score, as well. Instead, check if you’ve been preapproved so that you can compare offers before applying.