Why Did My Credit Score Drop After Paying Off Debt?
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Don’t be alarmed if you see your credit score drop a few points after you pay off debt. It’s normal, and there’s no need to panic. Here’s why it happens and what you can do about it.
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Check your credit report for errors
The first thing you should do if you see a drop in your credit score after paying off debt is to check your credit report for errors. If there are any errors on your report, you can dispute them with the credit bureau and have them removed.
If there are no errors on your credit report, the drop in your credit score may be due to the fact that you no longer have any unpaid debt. This might seem counterintuitive, but one of the factors that determines your credit score is your “credit utilization ratio.” This ratio measures how much of your available credit you’re using at any given time.
If you have a lot of debt and you pay it off, your credit utilization ratio will go down, and that can cause your credit score to drop. The good news is that as long as you don’t rack up more debt, your credit score will eventually go back up.
Understand how credit scores are calculated
Your credit score may have dropped after you paid off debt for a few reasons:
1) You closed a credit card account
When you close a credit card account, you lose the available credit limit on that account. This causes your credit utilization ratio to increase, which can lead to a drop in your credit score.
2) Your credit mix has changed
Your credit mix is the variety of accounts you have (credit cards, installment loans, etc.). A diverse mix of accounts is generally seen as favorable by lenders. So, if you paid off an installment loan (like a car loan), your score may drop because you no longer have that type of account in your mix.
3) You no longer have a positive payment history on that account
If you paid off an account and then closed it, you lose the positive payment history associated with that account. A long history of on-time payments can improve your credit score, so losing that history can cause your score to drop.
Consider the impact of closing accounts
One potential reason your credit score could drop after paying off debt is that you closed the accounts associated with that debt. Once you close an account, it’s no longer factored into your credit utilization ratio — and that could lead to a lower credit score, all things being equal.
What’s more, closing an account means you have one fewer open account on your credit report. That lowered number of open accounts could also lead to a lower credit score — again, all other factors being equal. So, if you’re thinking about closing an account after paying it off, you might want to consider holding off until you’ve opened and maintained another account for a while first.
Understand the difference between good and bad debt
Good debt is debt that is used to purchase an asset that will appreciate in value, such as a home or an education. Bad debt is debt that is used to purchase a liability, such as a car or a credit card balance. When you pay off bad debt, your credit score may drop because you are now perceived as being less financially responsible.
