Paying off debt is a significant accomplishment, but it can slightly pull down your credit score. Discover why this is the case and why it matters.
The age of your credit history is one of the major factors affecting your credit score. When you pay off a debt, you close that credit account, reducing the age of your credit history. It may also hurt your credit mix. However, experts suggest you do not put off paying off debt just because of a drop in your score.
Learn more about the impact of debt on your credit score, as well as how that affects your decisions.
Why Paying Off Debt Decreases Your Credit Score
For those looking at applying for a loan, knowing your credit score and how it is calculated will make a difference. There are a few factors you need to consider, including when it comes to your debt.
What Affects Your Credit Score?
If you feel like you need an advanced degree to figure out what goes into tallying your credit score, you are not alone. The good news is there isn't much to it once you have some information.
The Five Factors Affecting Your Credit Score
Each scoring bureau will have an exact set of criteria they use to come up with your score, and it can vary to some degree. With that said, here are the five most common factors companies use to determine your credit score. For each, we've included the weight it has on your FICO score, which is one of the most common measures of credit.
This is the single most important factor used to determine your credit score. If you have a missed payment, there may be a negative mark on your score. This is because lenders want to make sure you will pay them back if they are considering lending to you. This tends to account for 35% of your FICO score and is used by 90% of the top companies lending money.
The next most important information used to determine your credit score is your credit utilization ratio. This is used to determine how responsible lenders think you are. The amount of revolving credit you are using is divided by the amount you have available. This gives a snapshot showing how good you are at managing non-cash funds. Those using more than 30% of their available credit should work to reduce that percentage. This credit utilization ratio makes up 30% of your FICO rating.
Credit History Length
This tells the agencies scoring your credit how long your history is. This accounts for 15% of your FICO score. This will include the age of your oldest credit account through your newest and then average all of them. Generally, the longer your credit history, the better your credit score is.
When you have a healthy mix of different accounts on your credit history, it will create a diverse portfolio of accounts. This can mean a student loan, credit card, car loan, and mortgage, as well as other credit products. This will show that you can keep tracking multiple lines of credit without making late payments. This accounts for 10% of your FICO score.
The number of credit accounts you have newly opened will be considered hard inquiries. This can drag your credit score down. This area makes up for 10% of your FICO score. Many accounts consider multiple hard inquiries a strong indicator you are an increased risk as a borrower.
Keep in mind that these hard inquiries are not just limited to opening credit cards. There is a hard inquiry any time you apply for a credit card or loan.
How Debt Affects Your Credit Score
Few factors come into play when looking at how debt affects your credit score. Explore more details and take a closer look at how it affects each factor that determines your score.
Types of Debt That Affect Credit Scores
There are typically two types of debts reported to credit agencies. Installment and revolving accounts keep track of your payment and debt history, and both are important to finding your credit scores.
This is the credit associated with cards, but it occasionally includes home equity loans. With these loans, you have a limit that you can spend. You must make the minimum payments according to how much of the balance you have used. This credit doesn't typically have a fixed term and therefore is revolving.
This credit is where you have a fixed amount to borrow, and you make monthly installments on that balance until it is paid off. Mortgages, car loans, and personal and student loans are all part of these types of credit.
How Do Different Accounts Impact My Score?
As mentioned, having a good credit mix or diversity is a common factor used in determining your score. Additionally, it is often the most frequently overlooked. Maintaining different lines of credit such as personal loans, credit cards, mortgages, and credit cards show your creditors that you are capable of managing several forms of debt simultaneously. It also helps with a better image of your finances and your ability to handle debt.
While those with less diverse accounts don't always have a worse score, the more types you have with excellent, on-time payment history, the better. Remember that a good credit mix makes up 10% of your FICO score.
How Paying Off Debt Affects Specific Factors of Your Credit Score
Out of the five factors that affect your credit score, paying off debt can influence two of these negatively.
Credit History Age
The first of these is the age of your credit history. Remember that this takes the average age of every account that you have open. Depending on your credit history, closing an account by paying off debt may reduce this average.
That is especially true for many young adults in the case of student loans. After all, most people take out student loans at age 18, making them one of the first to appear on their credit report. The same can also be said if you close a credit card you opened at a young age.
Importantly, the extent to which paying off a loan reduces your average credit history age will be unique to your history. If you have many other loans or credit cards of a similar age, you will notice a smaller impact than if most of your loans and credit cards were opened in the last few years.
The other major factor it affects is your credit mix. Your credit score is higher if you have both revolving and installment loans.
So, if you pay off a loan that was your sole installment loan, you will likely notice a drop in your credit score. But if you have other installment loans, there will not be as large of a drop, if any at all.
How Other Debt-Related Actions Affect Your Credit Score
Paying off a loan, paying on time, and closing credit cards aren't the only ways debt affects your credit score.
Most importantly, remember that when you miss payments, your credit score will drop. If you do not see a method of catching up with your debts, you can declare bankruptcy, use debt consolidation, or use debt settlement. But these can all negatively affect your credit score.
Those negative effects can last months if not years. Even with the impact on your credit score, however, it is sometimes still worth it to use one of those options. You need to look at the bigger picture with your finances. That is part of the reason you should always consult a financial expert before declaring bankruptcy or using debt consolidation.
So, Should I Leave an Account Open?
Given that paying off a loan or closing an account can hurt your credit mix and the average age of your credit accounts, you may wonder if it is still worth closing or paying off.
This depends on the type of account and your financial situation.
As a general rule of thumb, you should leave credit cards open once paid off unless there is a good reason not to. For example, if the credit card has an annual fee, go ahead and close it. Or, if it will tempt you to overspend, close the card.
Just remember that your credit card issuer may close your account for lack of activity. It may be smart to occasionally use the card for small purchases and set it to autopay, so you don't miss any payments.
It is a different story with installment loans. That is because they will close automatically when you pay them off. So, you need to keep a small balance for it to stay open. But if you leave it open with a small balance, you will accumulate interest. That is an unexpected expense.
As such, financial experts suggest that you do not avoid paying off a loan or debt just because of the potential drop to your credit score. Your score will rebound.
When you pay off a debt, that account automatically closes. This may reduce the average age of the accounts listed on your credit score and hurt your credit mix. These factors influence your credit score, so the score may drop slightly. However, you can minimize the impact of closing an account on your credit by maintaining a good score overall. Additionally, you should not delay closing an account because of concerns about your score. You don't want to pay interest fees that you don't have to.
Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on Forbes, The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.