Why did my credit score drop after paying off debt?

Your credit score may drop after you pay off debt because the credit scoring system factors in things like your average account age and credit mix. If you applied for a loan to consolidate debt, the lender’s hard credit inquiry can also ding your score. The dip may be disappointing, but in most cases, it’s a temporary drop that can be recovered in a few months.

However, the types of debts you clear out and how you pay them off can cause a permanent drop if you don’t understand the factors impacting your credit score. Understand how they work and continue engaging in good money management, which you can do without taking on additional revolving debt if you choose. These steps can help you maintain a good credit score and get the best terms on money you borrow in the future.

Why credit scores can drop after paying off a loan

There are several reasons a credit score drops after a debt payoff. Most are related to the type of debt you pay off, how you pay it off and whether you keep the account open. The credit scoring system weighs many different factors when you pay off debt. Some impact how much your score drops more than others.

We’ll focus on the FICO credit scoring model, the most popular among lenders. Other models look at similar factors but weigh them differently.

You missed a payment before your debt was consolidated

Payment history makes up 35 percent of your credit score under the FICO model. A missed payment can tank your score faster than anything else. Whether you’ve been approved for a debt consolidation loan or a cash-out refinance on your home to consolidate debt, don’t rely on the lender to make on-time payments. Even if the lender offers to pay the creditors directly, check with your creditors to ensure it actually happened.

You’re still responsible for the payments, and your credit score will suffer if they’re late. If you end up paying a few dollars more than you owe, the creditor will refund you.

You accidentally increased your overall credit utilization

This can happen if you pay off multiple credit cards and close them out but leave balances on other smaller cards. Your credit utilization ratio measures how much total available credit you use and makes up 30 percent of your score. The lower the ratio, the better it is for your score. As a rule, your credit utilization ratio should stay under 30 percent to avoid hurting your score.

When you close out credit cards, you reduce your available credit. Even if your remaining balance is small, your credit score could take a hit if it raises your utilization ratio above the 30 percent threshold.

On the surface, this looks like a great plan. You just converted $2,750 worth of debt into an installment loan and eliminated the temptation to use the other $7,000 in the future.

But there’s a problem. Previously, you had $3,000 in total outstanding balances out of $10,000 available. Divide $3,000 by $10,000 and you’ll find you had a 30 percent credit utilization ratio before paying off your debt.

You now have only $500 in available credit. With a balance of $250, 50 percent of it is in use — compared to just 30 percent before. Despite all the revolving debt you paid off, your credit score will drop because of the spike in your credit utilization on the credit you have left.

This is why we recommend against canceling credit cards you’ve paid off, even if you don’t plan to use them again.

You’ve lowered the average age of your accounts

Closing out accounts you’ve had for a long time, even if you haven’t recently used them, can lower your score. The length of your credit history accounts for 15 percent of your credit score. A sudden change in the average age of your open credit accounts could make your score fall.

You paid off your only installment loan or revolving debt

Creditors like to see that you can manage a mix of installment debts like loans and revolving debts like credit cards. For example, if you paid off your only personal loan and don’t have other installment loans (like a car loan), that could cause a small dip.

But don’t let this prevent you from paying off debt. Credit mix only makes up 10 percent of your score. You can build good credit by focusing on optimizing the other factors rather than taking on or keeping debt you don’t need.

You took out a new loan to pay off other debt

Credit bureaus look at new inquiries on your credit. If you apply for a new loan to pay off other credit accounts, your credit score could drop a few points. This temporary blip will usually correct itself a month or two after the hard inquiry.

What factors impact your credit score?

Before you apply for any new credit, it’s a good idea to brush up on the factors that affect your FICO score. While there are other credit scoring systems, many lenders look at the FICO score when deciding whether to approve you for credit.

• Payment history (35 percent). Payment history is the top credit factor. The bottom line: Always pay your accounts on time to prevent major score drops.
• Credit usage (30 percent). Your credit utilization ratio is nearly as impactful. The less available revolving credit you use, the higher your credit scores will be.
• Length of credit history (15 percent). Before you start closing out accounts you’ve paid off, consider the average age of all of your accounts, the age of your oldest account and the age of your newest account.
• Credit mix (10 percent). Having a diverse mix of credit accounts like a car loan and one or two credit cards that you use and pay off helps you score well in this credit score component.
• New credit (10 percent). Applying for multiple new credit accounts in a short time could decrease your score more than applying for just one. If you’re shopping for loans, try to pick lenders that offer prequalification, which doesn’t require a hard inquiry on your credit. However, don’t let a hard inquiry keep you from shopping around for the best rate on a loan. You just need to keep all your applications within a two-week period so they’ll be grouped into a single inquiry.

How long does it take for your credit score to improve after paying off debt?

It can take months to years to see an improvement in your credit score after you pay off debt, depending on why the score dropped.

After paying off revolving debt, your score typically recovers in a few months so long as you leave the cards open, stay under a 30 percent utilization ratio and keep up with payments. The same is true of a drop due to a credit inquiry. Your score should recover a month or two later as long as you avoid any new credit inquiries.

Drops related to late payments, credit mix and length of credit score take more time to improve. Your payment history will gradually boost your score as you make future payments on time. The credit mix score will improve as you open a variety of different installment and revolving accounts. The length of your credit history increases the longer you keep accounts open.

5 ways to increase your credit score after paying off a loan

To increase your score after paying off a debt, you must know how that debt affected your overall score.

1. Pay everything on time

Consider setting up automatic payments on any credit you have to avoid missed payments. Learn the grace periods on your accounts, and never rely on a lender to pay your debts off even if they’re being paid through a debt consolidation.

2. Keep your credit utilization ratio low

Your credit utilization ratio is calculated by dividing the balances you carry by your total credit limit across all your cards. Spending no more than 30 percent of your available credit can keep this ratio low and lift your credit score.

3. Avoid closing out older credit accounts

Keep at least one or two older credit accounts open, even if you never use them. This shows the lender that you’ve been able to manage credit longer. And it tells them you’re likely to do the same with new accounts in the future.

4. Limit new credit inquiries

Even if you’re shopping for the best rate to consolidate your credit, too many hard inquiries tell the credit scoring model you may be opening many new credit accounts. Prioritize lenders that offer prequalification without a hard inquiry. And keep your applications with lenders that require a hard inquiry to a 14-day window to minimize the credit score impact.

5. Optional: Diversify your credit portfolio

Lenders want to see if you can handle regular fixed payments like installment loans and revolving credit like credit cards. Installment debt requires discipline to budget for the amount every month while revolving credit requires you to keep track of how much available credit you use.

If you can manage both well, you’ll see an improvement in the credit mix portion of your credit score. However, as this makes up only 10 percent of your credit score, do not feel the need to take on unnecessary debt just to improve your credit score. Keeping your overall finances healthy is more beneficial in the long run.

The bottom line

Ultimately, paying off debt is a healthy financial decision, even if it leads to a slight drop in your credit score. Most of the drops are temporary, but it’s important to understand some factors that could have a greater and longer-lasting negative impact on your credit scores. Keeping your payments current, using different credit types and keeping your credit utilization low are the best ways to preserve your credit score.

Frequently asked questions

• Should you always pay off your debt?

  Yes, unless it depletes all your cash or requires you to use money from an emergency fund. The fastest path to wealth building is to avoid paying interest so that all of your earnings can work for you without paying interest to a lender.

• Can I pay off debt without lowering my credit score?

  Yes, if you use cash and pay off credit card balances. Revolving debt balances and credit inquiries have an immediate effect on your credit scores, so paying the balances down with money you have in the bank gives you two benefits. First, you improve your credit utilization ratio, which boosts your score with no negative side effects. Second, using cash helps you avoid a credit inquiry that would be required if you use a debt consolidation loan to pay off debt.

• How do I keep my credit score from dropping?

  Pay your credit on time. Use credit cards as little as possible. Avoid paying off old credit accounts or relying on only one type of credit for all of your borrowing. Only apply for one credit account at a time. One or a combination of these tips can keep your score from sliding down.