Paying off debt can feel like holding your breath in a very long tunnel. Maybe you’re taking big deep breaths as you prepare to tackle it, maybe you can see the light at the end of the tunnel, or maybe you just came out the other end and can let out a giant sigh of relief. Wherever you are on the journey to pay off debt, the important part is that you are moving in the right direction.
Paying off debt is an important part of securing financial freedom; it will ensure less of your money goes towards interest and allows you to put more money towards other important goals such as saving for a car, home, or investing in your new business idea.
So, if it’s such a good thing, why does completely paying off a debt negatively impact your credit score? If you’re thinking “Wait, back up. Paying off debt will lower my credit score?” you aren’t alone. Many people don’t find out that their score can drop a few points when they pay off a debt until they pay off a debt. Building and managing credit is not something we are taught in school, rather we learn as we go. So, what is a credit score in the first place and why should you care if it drops a few points? A credit score is a number between 300 and 850 that indicates your “creditworthiness.” Lenders use your creditworthiness as a measure of how reliable a borrower you are before issuing loans and credit cards. The higher the number, the more reliable lenders will think you are and the more likely you will be able to secure credit cards and loans at low interest rates.
Your credit score is based on a number of things—let’s break them down:
Payment History: You are probably the most aware of how your payment history impacts your credit score. Pay your bills on time and your score goes up, pay your bills late or never and your score goes down. Pretty straightforward, right? If you nail this one, you’re setting yourself up well for a good to excellent credit score because your payment history impacts your credit score more than anything else.
Credit Utilization: How much of your available credit (add up all of your credit card limits) you actually use (add up how much you spend on all of those credit cards) is also highly influential on your credit score. A good credit utilization rate is under 30%. Ideally, you would use 10-15%. So, if the total of your credit card limits is $10,000, you should spend no more than $3000 per month across all of those cards.
Age of Credit: The longer your credit history, the better your credit score. So, if you opened a credit card on the first day of freshman year, keep it open even if you don’t use it, that is, as long as there is no annual fee and you pay it off in full every month.
Mix of Credit: Yes, there are different types of credit, and having a mix of the different types is good for your credit score. These types include credit cards, mortgages, car loans, and student loans.
New Credit: Any new credit lines you open or even just apply for, and how many, within the last year will affect your credit score negatively. This isn’t a big deal as long as you don’t make a habit of applying for multiple credit cards at once. Also, don’t do yourself a disservice by applying for a credit card that you know you will not get approved for and run the risk of dinging your credit for no reason. When you apply for a credit card, you are giving the creditor permission to do a “hard pull” on your credit. With a hard pull, a creditor requests a full look at your credit report to determine your creditworthiness. These types of “hard inquiries” may ding your score an average of 5-10 points.
Tip: Many credit card issuers provide pre-qualification links on their website where you can check to see if you may qualify for their credit card without doing a full application. The pre-qualification form asks you limited questions (typically your name, address, and the last four digits of your social security number) and the card issuers then do what is called a “soft pull” to your credit. Soft inquiries do not ding your credit score like hard inquiries do.
So why does paying off your debt lower your credit score?
First, it could decrease the age of your credit history. When you completely pay off an account or close it, it is no longer a part of your credit history. If your student loans are your longest-standing credit accounts, paying them off will decrease the average age of your credit, and thus decrease your credit score.
Secondly, it could raise your credit utilization, which also could lower your score. With one less account, you have less available credit, which means the amount of credit you are using could go up.
Finally, it decreases your mix of credit because you have one less type of credit amongst your total accounts. A decrease in credit mix = a decrease in credit score.
But…there is good news.
Yes, your credit score may drop temporarily when you finally pay off your debt, but don’t be alarmed. If you follow these simple steps, your credit score will bounce back in no time:
Pay your bills on time. Easier said than done, we know, but it really makes a difference. In just six months of paying your bills on time, you’ll be able to see a notable difference in your score.
Don’t close your credit card accounts. It may seem counterintuitive, but leaving a credit card open and not using it can actually be good for your credit score and report. Additionally, constantly opening and closing accounts could affect your credit utilization rate poorly.
Increase your credit limit. This will decrease your credit utilization rate, which will improve your score. If you are in good standing with your creditor, you should easily be able to increase your limit with a quick phone call or request online.
Simple, right? You can breathe easy again knowing your credit score will recover if you continue to handle your debt responsibly.
While important, your credit score is just one part of your credit report, not the entire picture lenders see. What is on your credit report contains a more in-depth look at your true financial situation. After paying off debt, you will be in a better financial position overall and that, as well as your peace of mind, isn’t measured by a pesky credit score. If it was, the number would soar.