Why Does Paying Off a Loan Lower Your Credit Score?

Paying off a loan can sometimes lead to a temporary decrease in credit scores, which may seem counterintuitive. This article explains why this phenomenon occurs, clarifying that it is typically a transient effect and does not diminish the financial responsibility of paying down debt. This temporary dip should not deter individuals from pursuing the beneficial goal of becoming debt-free.

Understanding Credit Score Components

A credit score represents an individual’s creditworthiness as a numerical value, indicating the likelihood of repaying borrowed money. Lenders use these scores to assess risk when evaluating loan or credit card applications. Several key factors contribute to a credit score, each carrying a different weight in various scoring models.

Payment History

Payment history holds the most significant influence on a credit score, typically accounting for about 35% of a FICO Score. This reflects whether past credit accounts have been paid on time. Timely payments demonstrate reliable financial behavior.

Amounts Owed

Amounts owed, often referred to as credit utilization, is another substantial factor, making up approximately 30% of a FICO Score. This measures total debt, especially in relation to available credit limits on revolving accounts. Maintaining low balances relative to credit limits is viewed favorably.

Length of Credit History

The length of credit history contributes around 15% to a FICO Score. This considers how long credit accounts have been established, including the age of the oldest account, the newest account, and the average age of all accounts. A longer history of responsible credit management is beneficial.

Credit Mix

Credit mix accounts for about 10% of a FICO Score. This assesses the diversity of credit accounts, such as a mix of revolving credit (like credit cards) and installment credit (like mortgages or auto loans). Managing different types of credit responsibly can positively influence this.

New Credit

New credit, representing recent applications, makes up roughly 10% of a FICO Score. Opening multiple new accounts quickly can sometimes signal higher risk, leading to a temporary score dip. Each hard inquiry can briefly impact the score.

Impact of Loan Payoff on Credit Factors

Paying off an installment loan, such as a car loan or mortgage, can temporarily affect your credit score. While debt elimination is a positive financial achievement, closing an account causes shifts in your credit profile. These shifts relate to your credit mix, credit history length, and overall debt management.

Credit Mix

Credit mix can be affected when an installment loan is paid off, especially if it was your only one. Credit scoring models favor individuals who manage both revolving credit (like credit cards) and installment credit, which has fixed payments over a set period. If closing an installment loan leaves only revolving accounts, it can reduce the diversity of credit types, potentially leading to a minor score adjustment.

Length of Credit History

The length of credit history is another factor that can see an impact. When an account is closed, it no longer contributes to the average age of open accounts. If the paid-off loan was an older account, its closure might reduce the average age of all active accounts, especially in some scoring models like VantageScore. While FICO scores consider closed accounts in their age calculations for up to 10 years, other models may not, leading to a potential decrease.

Credit Utilization

Credit utilization is a significant factor in credit scoring, but its interaction with installment loan payoffs is often misunderstood. It primarily refers to the percentage of available revolving credit being used. Paying off an installment loan reduces overall debt, which is beneficial, but it does not directly lower the revolving credit utilization ratio. This ratio is calculated based on credit card balances versus limits, not the balance of installment loans.

Payment History

While the positive payment history of a paid-off loan remains on the credit report for up to 10 years, new on-time payments cease. The account can no longer actively contribute fresh positive data points to payment history, the most influential scoring factor. The absence of an active installment loan, especially if it was your only one, can also influence how credit scoring models assess risk, as some models consider a low installment loan balance-to-loan amount ratio less risky than having no active installment loans at all.

Interpreting Credit Score Fluctuations

Observing a temporary dip in a credit score after paying off a loan can be concerning. However, such changes are typically minor and temporary, especially for those with strong credit profiles. The benefits of being debt-free generally outweigh any short-term score adjustments.

Being debt-free offers long-term financial advantages that are not always immediately reflected in a credit score. Eliminating loan payments frees up disposable income for savings, investments, or other financial goals. This improved cash flow can also lead to a better debt-to-income ratio, a metric lenders consider for future borrowing.

Paying off debt is a responsible financial action that enhances an individual’s overall financial health. A temporary score dip should not deter anyone from pursuing debt elimination.

To maintain a healthy credit score after a loan payoff, focus on responsibly managing remaining credit accounts. Make all payments on time for active credit cards or other loans. Keeping credit card balances low, ideally below 30% utilization, helps sustain a favorable credit utilization ratio. Avoiding unnecessary new credit applications can also prevent further hard inquiries that temporarily affect the score.