According to the Federal Reserve bank of New York, Americans have a net household debt of over $14 trillion.
More than half of the US adults (51%) are reeling under the pressure of debt, per a survey by Bank of America..
If you have debt, whether it’s student loan debt, credit card debt, a mortgage, or vehicle, you can no doubt relate to the high level of stress debt can cause. Many feel that they’ll have debt for the rest of their lives (especially student loans!).
Considering that debt could be a pain point for most people, wouldn’t it be good to pay it off?
But, did you know that several people have reported that after paying off a loan their credit scores dropped?
Some would consider this a Catch 22.
There are multiple reasons out of which your credit score may plummet after paying off a loan. Let’s find out why this could happen and whether you should worry about it.
Why did your credit score drop after paying off a loan?
So, you started saving money, left bad money habits behind, and paid off a debt, but to your surprise, your credit score dropped!
In order to understand the reason behind any decline in your credit score, let’s first understand the composition of your credit score.
Your FICO score takes into account five factors, including:
- Payment history (35%)
- Current debt (30%)
- Length of your credit history (15%)
- Credit mix (10%)
- New credit (10%)
A change in any of these factors could either boost or drop your credit score.
When you repay your existing loan, one of these things could lead to a decline in your credit score.
- If you paid off your oldest installment loan, the lender would automatically close your account. The closure of an old credit account creates temporary instability in your credit history, and hence, your credit score might drop. You should remember that a paid-off loan (with no late payments) will stay on your credit history for as long as ten years, though it’s significance will decrease with time.
- In some cases, if you paid off a loan that created a healthy credit mix, you may witness a drop in your credit score. It’s always good to maintain different kinds of credit lines. We actually are awarded a few additional points for having a diverse credit profile.
- A higher credit utilization rate could be another reason for a drop in credit score. If you paid off a credit card and closed the account, your overall available credit limit could drop, which could trigger higher credit utilization. As a result, you might witness a drop in your credit score.
- Another potential reason could be high balances on your remaining accounts, especially if the account you closed was the only one with a low balance.
You must understand that any of these factors could cause a drop in your credit score. Also, it’s likely that it is a mere coincidence, with no relation to any of these parameters.
Should I keep my debt to preserve my credit score?
So, should I keep my debt instead of paying it off?
Never! It’s always a good idea to repay your debt, even if it leads to a temporary drop in your credit score. Always remember that paying off a loan will not only provide you with greater control over your life, but you can also use that additional money to achieve your long-term goals.
If you are planning to pay off a credit card balance, we recommend you to avoid closing the account (if it is a quality credit card). Also, make sure that a small recurring payment is made to at least one of your credit cards each month and to pay it off in full at the end of every billing cycle.
5 Tips to keep your credit score in good shape
- Always pay your bills on time. A late payment can stay on your credit report for as long as seven years, so avoid making late payments.
- Try not to apply for multiple non-auto/mortgage credit applications at once. Even if you’re in desperate need of credit, we do not recommend completing multiple applications for new credit at once. Every hard inquiry could bring your credit score down a couple of points. Seek advice from an expert and find alternative ways to access credit.
- Keep your credit utilization low. Research indicates that people with a credit utilization rate of under 10% of their approved credit limits maintain the highest credit scores. You should try to keep it under 10% and no more than 25% at the highest.
- Do not close old credit card accounts without a plan. If you’ve just paid off a credit card, do not rush into closing the account without first seeing how it will impact your utilization. Closing the account immediately will lower your overall credit limit, thereby increasing your credit utilization rate, which can decrease your credit scores.
- Be careful about credit report errors. Last but least, you should be cautious about errors on your credit reports. Review your credit reports on a regular basis and dispute any errors as soon as you notice them. You’re entitled to at least one free credit report annually from all three credit bureaus (Equifax, TransUnion, Experian).
Many people may find it frustrating to witness a drop in their credit score after paying off a bill. You’re trying to do the right thing, so why would it happen? Allow us to reassure you, it was the right decision, and the drop is temporary. Your credit score will come in-line as you continue to exhibit good financial behaviors.
Always remember that your credit profile is a total of your overall financial behavior, so having good money habits or paying off debts could never go wrong!