Why Does Your Credit Score Go Down When You Pay Off a Loan?

Individuals may be surprised to see a dip in their credit score after paying off a loan, an action often associated with financial responsibility. This counter-intuitive phenomenon can cause confusion, as one might expect an immediate improvement rather than a decline. The reason behind this temporary reduction in a credit score lies within the complex algorithms credit scoring models use to assess an individual’s creditworthiness. This article explains how paying off and closing a loan account can influence various components of a credit score.

Understanding Credit Score Components

Credit scores are numerical representations of an individual’s credit risk, calculated by various models like FICO and VantageScore. These scores are derived from information in credit reports maintained by major credit bureaus. While exact formulas are proprietary, the general categories of information considered are publicly known and weighted differently.

Payment history (approximately 35% of a FICO Score): Reflects on-time payments.
Amounts owed (credit utilization, around 30%): Indicates how much credit is used relative to total available credit.
Length of credit history (about 15%): Considers the age of credit accounts and the average age of all accounts.
New credit (approximately 10%): Includes recent applications and new accounts.
Credit mix (remaining 10%): Assesses the diversity of credit accounts (e.g., installment loans, revolving credit).

Impact on Credit Utilization

Paying off an installment loan, such as a car loan or a mortgage, often results in the closure of that account. When an installment loan closes, the associated credit limit is removed from the total available credit. This reduction in total available credit can impact the credit utilization ratio, especially if an individual carries balances on other revolving credit accounts like credit cards.

The credit utilization ratio is calculated by dividing the total amount of revolving credit used by the total amount of available revolving credit. For instance, if an individual has $5,000 in credit card balances and $10,000 in total credit card limits, their utilization is 50%. If an installment loan closes, and that individual’s total available credit decreases because no new revolving credit is obtained, their utilization ratio on remaining revolving accounts could appear higher even if their balances haven’t changed. This higher utilization ratio can lead to a temporary decrease in the credit score because lower utilization is generally viewed more favorably by credit scoring models.

Conversely, paying off a revolving loan, like a credit card balance, directly improves the credit utilization ratio by reducing the amount owed while the credit limit remains available. This distinction between the effects of paying off an installment loan versus a revolving loan is important for understanding credit score fluctuations. The closure of an installment account removes the associated credit line from the overall credit landscape, potentially altering the utilization calculation for remaining revolving accounts.

Impact on Credit Mix and Account Age

The closure of a loan account, particularly an older one, can affect the length of an individual’s credit history and their credit mix. When an older loan account is paid off and closed, it can reduce the average age of all active credit accounts. Credit scoring models generally favor a longer average credit history, as it demonstrates a more extended period of responsible credit management.

Furthermore, closing an installment loan can impact the credit mix. A diverse credit mix, which includes both installment loans (e.g., mortgages, auto loans) and revolving credit (e.g., credit cards), is generally seen as beneficial by credit scoring models. This diversity demonstrates an individual’s ability to manage different types of credit responsibly. When an installment loan is paid off and closed, it can reduce the variety of credit types reported on a credit report, potentially lowering the score due to a less diverse credit portfolio. The removal of an installment loan from an active credit profile means one less type of credit is being actively managed. While the payment history of the closed account remains on the credit report for up to 10 years, its status as an open and actively managed account changes.

The Temporary Nature of the Dip

The credit score dip experienced after paying off a loan is typically temporary and often recovers, or even improves, over time. While closing a loan can initially impact factors like credit utilization and credit mix, the most significant factor in credit scoring remains payment history. Consistent, on-time payments on all remaining credit accounts continue to build a positive credit history, which is the primary driver of a strong credit score.

As positive payment behavior persists across other active accounts, the impact of the closed loan account lessens. The credit scoring models will eventually weigh the ongoing responsible management of other credit lines more heavily than the immediate effects of a single account closure. The underlying financial action of eliminating debt is a positive step, and credit scores tend to reflect this improved financial health in the longer term. This recovery demonstrates that while specific events can cause minor fluctuations, sustained positive credit habits are what ultimately determine an individual’s credit standing.