The day you finally pay off debt is cause for celebration. This milestone can take months, years, or even decades, depending on the debt. What you may not have expected along with this celebratory time is a dip in your credit score. Here’s what you need to know about why you may be seeing a drop in your credit score after paying off your debt.
How is my credit score calculated?
Your credit score reflects your ability to manage debt. And it might seem counterintuitive, but paying off debt can actually cause a slight decrease in your credit score. That’s because of the elements used to calculate your score.
FICO, one of the most popular credit scoring methods, uses the following five criteria to build your credit score:
- Payment history (35%): The most prominent factor in calculating your credit score is how you’ve managed past credit payments. Your score increases with payments that are on time and in full.
- Amounts owed (30%): Also known as credit utilization, the amounts owed category looks at how much debt you currently have vs. your overall available credit. Your score often increases if you keep utilization below 30% of available credit.
- Length of credit history (15%): Credit history consists of how long your accounts have been open and the most recent activity. You’ll often receive a higher score in this category for a lengthier credit history.
- Credit mix (10%): Creditors want to see a good mix of credit instead of lots of debt in one sector, like credit card debt. Lenders—and the credit reporting bureaus—prefer to see borrowers that use a different mix of loan types, like mortgage, credit cards, or installment loans.
- New credit (10%): In general, it’s wise to only apply for the credit you need and plan to use. You might get dinged in this category for applying for too much new credit at once, as each new credit application triggers a hard credit inquiry.
How does paying off my debt change my credit score?
When you pay off a debt, it means that debt is no longer reported as part of your credit report or score. For example, let’s say you just paid off and closed a home equity loan. The following elements of your credit score may be negatively impacted:
- Amounts owed: With less available credit, your credit utilization may increase. That’s because the debt you still carry will be a larger percentage of your available credit. For example, let’s say the debt you paid off was a $10,000 loan, and your only remaining debt is a credit card with a $3,000 balance on a $6,000 credit line. Suddenly, your credit utilization goes from $3,000/$16,000 = 18.75% to $3,000/$6,000 = 50%. That kind of shift could result in a dip in your credit score.
- Length of credit history: If the debt you pay off is one you’ve had the longest, you could lose points toward your length of credit history. But if you maintain other debts, including the longest-running debt, you may not see a decrease in this area.
- Credit mix: If the debt you repaid was the only debt you had in a specific category, your credit mix score could take a hit. In our example, moving from an installment loan and a revolving debt to only a revolving debt could decrease your score by a few points.
Can I improve my credit score after debt payoff?
Most of the negative implications of paying off debt are short-term. And proper financial management and a solid debt paydown strategy can ensure your score doesn’t see long-term effects. Here are some tips to improve your credit score after debt payoff.
- Calculate your debt paydown strategy: There are strategic ways to pay off your debt to save you money on interest while also limiting negative implications for your credit score. The debt snowball and debt avalanche are two popular strategies that attack your smallest debt or highest interest debt first, respectively.
- Continue to make timely payments on remaining debt: You’ll want to stick with your repayment plan and make sure to pay on all remaining debts timely. This can help you avoid any bad marks in your payment history.
- Consider keeping debts open if possible: If the debt you’re paying off is a credit card, consider leaving the line of credit open instead of closing it out. Doing so could help maintain your credit history and give you more available credit. Be sure to make small charges on the card regularly to avoid fees or closure related to inactivity.
The bottom line
Paying off debt is an excellent financial strategy. And being smart about how you choose to pay debts can help to alleviate any negative implications for your credit score. If you do see a dip, keep in mind it’s generally short-term, and you can always work to improve your credit score through intelligent debt management.
Brooke is a freelancer who focuses on the financial wellness and technology sectors. She has a passion for all things wellness and spends her days cooking up healthy recipes, running, and snuggling up with a good book and her fur babies.