4 Reasons Your Credit Score Dropped After Paying Off Debt

You’ve always heard that paying off debt is good for your credit. But when you do succeed in paying off a loan or credit card, something truly unexpected might happen — your credit score drops. 

Why is this happening? Shouldn’t your score be going up? 

In actuality, there are some common reasons your credit score might decrease when you pay down debt: 

Reason #1: You closed one of your older credit accounts. 

Your FICO Score is determined based on a number of weighted factors. One of those components is the length of your credit history, which accounts for 15% of your score. Consequently, your score considers how long each of your active loans and lines of credit have been open. And the methodology examines the average age of each those credit accounts. 

In general, a longer credit history translates to a higher credit score. 

But what happens when you pay off a loan? At that point, your lender officially closes that account. Since the loan is no longer active, it’s not considered in the calculation of your average credit age. If your loan was one of your older credit accounts, you’ll likely experience a drop in your average credit age. And that drop might cause a slight decrease in your credit score. The same process happens when you close a line of credit. If the line you shut down is one of your older credit accounts, you’ll inadvertently lower the average age of your active credit accounts. And that might precipitate a drop in your credit score. 

Reason #2: You altered your credit mix. 

In addition to considering your credit age and other factors, FICO also uses your credit mix to determine your credit score. Accounting for 10% of your score, credit mix is defined as the variety of credit accounts you have. 

There are two main types of credit accounts: 

• Installment loans: Loans typically offer a lump sum of cash upfront that you subsequently pay off in monthly installments. Once the payment term ends, your loan is closed. Popular forms of installment loans include mortgages, car loans, student loans, and personal loans. 

• Revolving credit: Revolving credit accounts offer you a line of credit from which you can withdraw or which you can spend as needed. You make payments each month, but the amount owed depends on how much you’ve withdrawn from the credit line. Popular types of revolving credit include credit cards, personal lines of credit, and home equity lines of credit (HELOC). 

Generally, your FICO Score tends to increase when your credit history shows you can manage both types of credit responsibly. If you close your only active loan or line of credit, your credit mix changes. And that shift can mean a small decrease in your credit score. 

Reason #3: You credit utilization ratio increased. 

The amount you owe your lenders is always a critical component of your credit score. And your credit utilization ratio (CUR) is a major part of that. Your credit utilization ratio looks at your revolving credit accounts and measures the percent of available credit you’re currently using. In other words, CUR is your total outstanding balance divided by your total credit limit across all your credit cards and lines of credit. 

For example, suppose you have two forms of revolving credit. Credit Card A comes with a $10,000 limit, while Credit Card B offers a limit of $15,000. So, your total available credit is $25,000. Now suppose you have a $3,800 balance on Card A and a $200 balance on Card B. Your total balance owed is $4,000. And your credit utilization ratio is 16% (which is $4,000 divided by $25,000). Typically, you want to keep your credit utilization ratio below 30% to keep your credit score healthy. (In fact, people with the highest credit scores have a CUR that sits around 7%.) But what happens if you pay off Card B and you close that account — or your lender closes it for you? The total amount you owe decreases by $200, which is a plus for your credit score. But, with that line of credit no longer active, it’s no longer counted toward your CUR. 

So now your CUR looks only at Card A. And your ratio is $3,800 divided by $10,000, or 38%. 

How did this happen? In closing Card A, you eliminated $15,000 from your pool of available credit. So, by closing one of your revolving credit accounts, you’ve dramatically increased your CUR and likely took a hit to your you credit score. Suppose instead that you had paid off Card B but kept it open. Now your credit utilization ratio is $3,800 divided by $25,000, which is 15.2% — a healthy figure for a good credit score! 

Reason #4: Your account history stuck around after you paid off your debt. 

When you paid off your account, did you expect that it would disappear from your credit report? Often, people are surprised to discover that those old accounts linger for years in their credit history. So maybe you have an account with some late payments on record or one that went to collections. Even if you pay off that debt, that history remains visible to people who view your credit report. 

If you were hoping to wipe the slate clean – and boost your credit score — by paying off that problematic debt, you’ll find that those black marks can remain on your report for up to seven years. Fortunately, the impact of negative history decreases rapidly as time goes on. So, even if those late payments stick around for years on your report, they’ll contribute less and less to your score over time. And lenders will eventually view them as insignificant if your more recent credit history is positive. 

What to do when your credit score drops after paying off debt 

Did it happen to you? Did you pay off debt and watch your credit score unexpectedly decrease? Tackle these next steps: 

1. Remember that paying off debt is a good thing! 

Paying off debt is a fantastic way to boost your financial health. After all, as you eliminate debt, you free up the money you would have been putting toward that debt. Instead of paying off the balance and interest each month, you can start allocating your cash toward your own financial goals. 

Plus, paying off debt and using your remaining credit responsibly will — in the long run — improve your credit history and boosts your credit score. 

2. Understand that the dip is usually small and temporary. 

A decrease in your credit score doesn’t mean that you’re headed in the wrong direction. Generally, a drop from paying off debt lasts no more than a few months and amounts to well under 100 points. 

3. Consider leaving your line of credit open after you pay it off. 

Remember that shutting down a credit card or other line of credit can reduce your total available credit and, in turn, increase your credit utilization ratio. So, even if you’re no longer using your credit line, think twice before closing it. If you do keep it open, charge something small every few months just to avoid having the line shut down for lack of activity. However, if you need to pay an annual fee or if you worry you’ll spend the available credit, go ahead and close your line of credit. 

4. Boost your available credit. 

In general, you shouldn’t take out a loan or line of credit just for the sake of increasing your credit limit and lowering your credit utilization ratio. However, you can ask your existing credit card issuers to boost your credit limit. Most financial institutions have an easy process for making the request through your online account. If you’re approved, you instantly increase your available credit. 

If you keep your spending the same — instead of using that new credit — your CUR will decrease, which could augment your credit score. The next time you pay off a loan or line of credit, remember that seeing a temporary dip in your credit score is common! And continuing your responsible credit habits will put you on the right track to a great score and a healthy financial life.