Why Did My Credit Score Go Down After Paying Off a Loan?

A credit score can sometimes decline after an individual pays off a loan. This may seem counterintuitive, as debt repayment is generally considered a positive financial action. Understanding this temporary dip requires insight into how credit scoring models assess an individual’s creditworthiness.

Core Components of a Credit Score

Credit scores, such as FICO and VantageScore, are calculated using various pieces of information from an individual’s credit report.
Payment history is a significant factor, reflecting whether bills are paid on time and consistently. This component holds considerable weight in credit scoring models.
Amounts owed, also known as credit utilization, refers to the proportion of available revolving credit currently being used. Lower utilization is viewed more favorably, with ratios below 30% of total available credit generally preferred.
Length of credit history considers how long accounts have been open. Older accounts generally contribute positively to the score.
Credit mix refers to the diversity of credit accounts, encompassing both revolving credit, like credit cards, and installment loans, such as auto loans or mortgages. A blend of these account types can positively influence a score.
New credit reflects recent applications for credit, as numerous recent inquiries can sometimes signal increased risk.

Understanding the Impact of Loan Payoff

Paying off an installment loan, such as a car loan or personal loan, can sometimes lead to a temporary reduction in a credit score. This occurs because the closure of such an account can subtly alter elements within credit scoring models. The impact is typically minor and temporary, but it can still be noticeable.

One mechanism involves the credit mix. When an installment loan is paid off and closed, it can reduce the diversity of credit types listed on a credit report, especially if it was one of the few or the only installment account. Credit scoring models view a healthy mix of both installment and revolving credit as a positive indicator of financial management. The removal of an installment account from an otherwise varied credit profile can therefore be perceived as a less optimal credit mix.

Another factor influenced by loan payoff is the average age of accounts. Closing an older, fully paid loan can slightly decrease the average age of all open accounts on a credit report. A longer average age of accounts is generally seen as more favorable by credit scoring models, indicating a history of responsible credit use.

Other Factors Influencing Your Score

A credit score decrease following a loan payoff might not be solely due to that event, as other financial activities can coincide and affect the score.
New hard inquiries occur when an individual applies for new credit, such as a credit card or another loan. This inquiry can cause a temporary, slight dip in the score, typically lasting for a few months.
Increased credit utilization on other revolving accounts, like credit cards, can also lead to a score reduction. If an individual pays off an installment loan but simultaneously increases balances on their credit cards, the higher utilization ratio on those cards can negatively impact the score.
Missed or late payments on any other account around the same time as the loan payoff can also be a cause. Payment history is the most influential component of a credit score, and even a single late payment can have a significant negative impact.
Undetected errors or fraudulent activity on a credit report can lead to unexpected score drops. Individuals have a right to obtain free copies of their credit reports annually to review for inaccuracies. Prompt review allows for identification and dispute of any incorrect information.