Paying off debt, and clearing your accounts take time, and a bit of financial commitment, depending on the amount and type of debt you have. However, it can feel somewhat dismal to realize that your credit score may have decreased after paying off your debt. Sounds a bit counterintuitive, right?
You’ve spent months, perhaps even years paying off your debt, and meeting payment requirements, only to realize that your credit score has decreased, something you’ve worked hard to build and maintain over the years.
Understanding your way around how your credit score is calculated, and the multiple factors taken into consideration to build your credit score can feel like a daunting experience for anyone. This could especially be the case if you’ve recently paid off debt, and now your score is lower than what you started with.
Luckily, there’s no need to fret, as there are ways to improve and rebuild your credit score if this might be the scenario.
How is a credit score calculated?
Before we can dive into the reasons why your credit score decreased after paying off your debt, we will first need to understand how your credit score is calculated, and what your credit report history means for your line of credit.
Your credit report history and credit score are generated by each of the three nationwide consumer reporting agencies (CRAs). All three of these CRAs - Equifax, Experian, and TransUnion - will obtain information about any open lines of credit you currently have.
This may include things like a credit card account, smaller personal loans, auto loans, or a mortgage loan taken out from a bank or lender. From this point onward, a credit bureau will calculate your creditworthiness using one of several formulas, and consider various other factors along the way.
In most instances, many credit bureaus will consider the following factors when calculating your creditworthiness:
Credit history length
In some instances, you might already have a credit history record, especially if you’ve opened a credit card account or taken out a small loan. The longer your credit history, the better your score will be, and vice versa.
Any credit accounts
Credit bureaus will factor in any existing accounts you may already have such as mortgages, auto loans, or credit cards. These all contribute to your credit mix, and in some instances, the more diverse your credit portfolio, the better.
Positive payment track record
Another factor that is used to calculate your creditworthiness is looking at your payment history, and whether you’ve missed any payments, or had late payments on your account. Missing payments can negatively impact your credit score.
New credit accounts
Any new or recent credit accounts opened in your name will contribute to your credit history. Additionally, the length of time you’ve had these accounts will be used as a measurement of your credit history.
Credit utilization ratio
Understanding credit utilization is often a bit more tricky, however, this typically underscores the amount of revolving credit you are currently using, divided by the total amount of credit available to you.
When does your credit score decrease after paying off debt?
Building a healthy credit record requires time and effort. More importantly, it requires you to make financial commitments to paying off any accounts on time, and avoiding any late payments or penalties, as this will negatively impact your credit score.
However, there may be instances where clearing your credit accounts by paying off all your debt at once can bring down your credit score. Keep in mind that not all large payments towards your debt will negatively impact your credit score, and this will often only change your utilization ratio.
While paying off your debt may help you in the near term, in the long run, this might affect your credit score history.
Closing an account
Building a steady credit score is a lot like investing, it often requires you to have a diverse mix of different credit accounts. These accounts will help creditors determine your credit utilization rate, and how much of your credit you’re using.
Let’s say that you have an active credit account, such as a credit card, or auto loan. Once you make a final payment on one of those accounts, the account will automatically close. This would in return mean that you have one less credit account and a seemingly less diverse credit portfolio.
While you might feel relieved to have this account paid in full, this could have an impact on your credit score, as you will now have one less credit account that contributes to your overall credit mix portfolio.
Lowering account age
As already mentioned, your credit score is calculated using the length or history of your credit accounts. Closing off one account, would not only mean that you have a less diverse credit portfolio, but it would also shorten the age of your credit history.
This typically happens when you decide to close an older credit account you don’t use anymore. You might be thinking of closing your old credit card account that you’ve opened years ago. The age of this credit card account has been used as a calculation to measure your credit utilization.
Closing one of your older accounts, even when you don’t use it anymore could reflect negatively on your credit history, as this would lower the overall length of your credit history. This is more common than you might think, however, closing one of your oldest accounts would mean a drop in your credit score.
Decreased credit utilization
Typically, lenders will calculate your available credit by using multiple factors to determine whether you’ve carried some debt, or whether you’ve made payments on time. Credit utilization refers to the amount of credit you have available, and how much thereof you are using.
Generally, using less available credit is better in the long run, as this would mean that you are not depleting your accounts, or overutilizing your available credit. The better you manage your credit, the better you stand to benefit from it in the long run.
The catch however is, that paying off a loan or closing a credit account would lower the amount of available credit you have across all your accounts, which in return decreases the credit utilization.
Resolving loans
Taking out a loan may often help increase your credit score, or even build your credit portfolio. Lenders will typically evaluate your financial health by reviewing your line of income, payment history, and existing credit history to determine your level of risk.
Once you have been approved for a loan, your lender will set up a monthly repayment plan, which typically stretches over several years, with fixed monthly payments. You as the borrower will begin to repay this loan over the agreed period, however, once you make the final payment on the loan, the account will be closed.
Seeing as a loan from the bank, or monthly installments are different compared to a revolving line of credit, such as a credit card account, these accounts will be cleared after a specific time, and zeroing the balance on your installment loan could impact your overall score.
For some people, this might have a temporary impact, especially if they already have a diverse mix of credit. For those that only have an installment loan as the primary account on your credit portfolio, your score will experience a more significant decrease.
Keep in mind that this may only be a temporary decrease, and you can start improving your credit score again by opening an active line of credit, or a new credit card account.
Time until credit reporting
Something that you might notice, once you’ve paid off your accounts, or any installment loans, is that your credit score might not decrease immediately afterward. Creditors may take up to 30 days to report these settlements to any of the credit bureaus, which will then reflect on your upcoming credit report.
You might experience a lag in the time from settlement until you can verify whether or not your credit score has been affected. Once you know how much your credit score has changed, either by increasing or dropping, you can then begin to determine what your next possible options may be to either maintain your current score or make improvements.
Five ways to improve your credit score
If your credit score has been impacted after paying off your debt, you will need to start considering what possible options you have available to start improving your score again.
Keep in mind that a drop in your credit score is only temporary, and while it may take some time to make improvements again, you will be able to regain the score you initially had before clearing your debt.
Maintain active accounts
One of the best ways to keep your credit score is to maintain any open and active accounts you currently have. While you may have one less account on your credit portfolio, those that are still active will help you maintain your credit reporting history.
Make monthly payments
Making monthly payments is another way to build your credit score. Make sure that you are meeting your payment agreements, and that you are not missing any important payment deductions. Consider setting up automatic payments, on your debit account, to ensure you don’t miss any payments. Remember that missing any payments can result in late payment fees, and account penalties, and can negatively reflect on your credit profile.
Open a new account
While you might enjoy having fewer credit accounts, try to open a smaller credit account that will contribute to your credit portfolio. You can consult with your bank, or a financial advisor to decide which type of credit account will be best suited for your position, and whether these lines of credit will help improve your credit score.
Avoid opening too many new accounts
Contrary to the previous point, you also don’t want to open too many new accounts. While this might often be needed, if you want to buy a house or car, too many hard checks on your account can negatively impact your credit score. Additionally, taking out too many different loans or lines of credit might also impact your credit score. Try to be more mindful of your financial habits and current needs.
Avoid collection accounts
Any account that is handed over to debt collectors will reflect on your credit report. Ensure that you don’t have any accounts that are past due and that any debt you may have outstanding can be settled with a payment plan.
If you have accounts that are approaching their due date or have already been handed over to debt collections, arrange a possible payback scheme that works with your budget. Additionally, you don’t want to keep these accounts past due for too long, as this will negatively impact your credit profile in the long term.
What’s the best way to prevent your credit score from decreasing?
While in some cases you might see your credit score drop after paying off debt, it’s advised that you maintain healthy financial habits that allow you to build your credit score, and not overutilize your available credit.
While paying off debt might impact your credit score, it’s not to say that you should avoid settling these accounts. You may find that opening a new line of credit, that is within your utilization rate will help you maintain a good credit score.
You will also need to ensure that you make monthly payments and that your accounts are not handed over to collections. Keeping an active, yet well-diversified credit portfolio will help you make the necessary improvements over time.
Final words
Paying off debt can be a major relief for many of us, however, we need to consider the negative implications this may have on our credit reports. Being aware of how your credit score will be impacted after paying off your debt or closing an account will help you better understand how you can steadily rebuild your credit score over time.
Keep in mind that this is only temporary, and it may take some time for the improvements to reflect on your credit report due to a lag in reporting from creditors to one of the three nationwide credit bureaus.
Don’t fret once you’ve noticed your credit score dropping after you’ve paid off your debt. Instead, focus on how you can maintain your active credit accounts, meet the monthly payment agreements, and avoid any accounts being handed over to collections. The more you begin to diversify your credit portfolio, the easier it will be to regain what you have lost.
