Whether you used a debt consolidation loan or a debt management plan or just kept hacking away at your balance month by month, paying off your debt is a weight off your shoulders. You might be surprised to find that your credit score drops after you do so. It’s a common misconception that paying off your debt will increase your credit score; unfortunately, that’s not the case. Paying off your debt could lower your credit score, preventing you from getting a loan in the future. Why does this happen, and what can you do to help get your score back on track? Here are a few ideas.
The factors affecting your credit score
Your credit score is a number in the range of 300 – 850, with 850 being the best score possible. To determine your score, the three major credit bureaus: Experian, Equifax, and TransUnion, weigh these factors:
Number of late payments
Your payment history is the most significant factor influencing your credit score, accounting for 35% of your total score. Payments made after your due date for any loan or credit account are reported to the bureaus, but generally, are only an issue when the payment is more than 30 days late.
Credit utilization rate
The next largest factor for how high of a score you’ll receive is your credit utilization rate. Credit utilization is shown as a percentage of how much outstanding debt you have over the total amount of credit available. It accounts for 30% of your credit score.
For example, if you have $100,000 in total available credit and carry a balance of $25,000, your utilization rate would be 25%. Experts recommend keeping your utilization rate under 20%, though those with the best scores typically utilize 10% or below.
Age of credit
Creditors want to know you can handle credit responsibly and will look at the average age of your open accounts. Your credit age accounts for 15% of your score. The highest scores typically have an average age of seven years or longer.
Types of credit accounts
10% of your credit score is based on the types of accounts you have, as lenders will want to see you’re able to handle a diverse number of accounts. Credit cards, car loans, mortgages, and student loans are the most common accounts.
Hard inquiries are made when a potential lender “pulls” your credit report to determine your eligibility. The more inquiries you have, the more lenders will be wary of offering you credit since it will appear that you’re desperate, even if that’s not the case. Soft pulls such as those on credit monitoring apps don’t affect this factor, so don’t worry if you’re using software to track your credit score. Hard inquiries should occur no more than 1- 2 times per year. This accounts for 10% of your overall score.
The reason why your score went down after paying off your debt
The most likely culprit for why your credit score dropped after paying off debt is that you closed your credit account. Closing a credit account after paying it off does a few things:
- It changes your credit utilization rate – If you have $15,000 in total credit but close your account that had a $5,000 limit, you’ve decreased your total credit by 1/3rd, which will significantly change your credit utilization rate, especially if you have other debt.
- It potentially affects your credit age – If the card or debt you’ve paid off is one of your oldest open accounts, closing it could drastically change the age of your credit and thus affect your score.
- It changes the types of accounts you have open – Removing your only credit card or car loan from your report changes the mix of accounts you have and can slightly lower your score, though not as much as the other two factors.
What to Know About Debt Management and Debt Consolidation Plans
Though paying off your debt is the goal it is good to be aware of some of the downsides of debt management and debt consolidation plans. With debt management plans:
- You can’t take out new credit: While you are in a debt management plan, you can’t apply for new credit.
- You will have to close your credit accounts: As referenced above, closing a credit card can temporarily lower your score. You may be able to keep one open though for emergencies.
- Not every creditor accepts debt management plans: Debt management plans aren’t always accepted.
Debt consolidation instead of a debt management plan may be an option to consider as it helps lower your credit card use and keeps your credit score intact. You just have to ensure that you will keep up with monthly payments. With debt consolidation, you will only see a temporary drop in your credit score but with on-time payments and a reduction in your credit utilization ratio, the score will rise.
The bottom line
Understanding how your credit score can fluctuate can get overwhelming quickly, especially when you’re doing the right things like paying down your debt. It may seem a little confusing at first, but once you understand the factors that go into calculating your score, you’ll be more informed and can take action to ensure your credit score bounces back no matter the reason that caused it to go down.