Why Would Your Credit Score Drop After Paying Off Debt?

A credit score decline after paying off debt can be confusing, as debt repayment is generally seen as a positive financial action. Understanding credit scoring models is essential to navigating these unexpected, often temporary, fluctuations. This article explains factors and scenarios that can lead to such a dip, emphasizing that paying off debt remains a beneficial long-term strategy.

Understanding Credit Score Building Blocks

Credit scores are numerical representations of an individual’s creditworthiness, influenced by several factors. FICO Scores, widely used by lenders, are calculated based on five main categories, each with a general weight. Payment history, reflecting on-time payments, is the most influential, typically accounting for about 35% of the score. The amounts owed, which includes credit utilization, represents approximately 30% of the score.

The length of credit history, considering the age of accounts and average age, contributes around 15% to a FICO Score. The types of credit used, or credit mix, and new credit, related to recent applications and accounts, each contribute about 10%. While VantageScore models use similar factors, their weighting might differ slightly, with payment history and credit utilization also being highly influential components.

How Revolving Debt Repayment Influences Scores

Revolving debt, such as credit card balances and lines of credit, allows consumers to borrow against an established limit, repay the amount, and then re-borrow. Paying off revolving debt typically leads to an improvement in a credit score by significantly lowering the credit utilization ratio. This ratio, which compares outstanding balances to available credit limits, is a heavily weighted factor in credit scoring models, and keeping it below 30% is generally advised for a positive impact.

However, a temporary score dip can occur in specific scenarios involving revolving debt. If the paid-off credit card account was the only active revolving account, its closure could reduce the overall diversity of credit types on the report. If an old, long-standing credit card is paid off and then closed by the consumer or the issuer, it might impact the average age of all open accounts. Although accounts with positive history can remain on a credit report for up to 10 years, the closure of an account can still influence the average age calculation.

How Installment Debt Repayment Influences Scores

Installment debt, which includes loans like auto loans, mortgages, and student loans, involves borrowing a fixed amount that is repaid in regular, scheduled payments over a set period. When an installment loan is fully paid off, the account is typically marked as closed on credit reports. This closure can sometimes lead to a temporary decline in a credit score.

One reason for this potential dip is the removal of an active account from the credit mix. While credit mix generally accounts for a smaller portion of a FICO Score (about 10%), having a diverse portfolio of both revolving and installment credit is often viewed favorably by scoring models. Therefore, if the paid-off loan was the only active installment account, its closure could reduce this diversity.

The closure of an installment loan can also affect the average age of accounts, particularly if it was an older loan and few other long-standing accounts remain open. While FICO models typically consider both open and closed accounts when calculating the average age of credit history, some VantageScore models may not include all closed accounts, which could shorten the perceived length of credit history. Additionally, once an installment loan is paid off, the scoring model no longer sees an active, ongoing payment history for that specific type of debt, even though the positive payment history remains on the report for years. This transition from an active, regularly contributing account to a closed status can cause a minor, temporary adjustment in the score.

The Impact of Account Changes on Credit History

While paying off debt can lead to temporary score fluctuations due to changes in account status, these dips are often minor and short-lived. Credit scoring models adjust to the new credit profile. The long-term financial benefits of debt repayment, such as reduced interest payments and improved financial stability, far outweigh any temporary score decline. Maintaining a history of responsible payments and a healthy credit mix remains key to a strong credit score over time.

Credit Score Model Differences

There is not a single, universal credit score; rather, various scoring models exist, with FICO and VantageScore being two of the most prominent. These models use different algorithms to weigh the various factors that comprise a credit score. Consequently, the impact of paying off debt, particularly an installment loan, can vary depending on the specific model used.

For instance, one model might place a slightly different emphasis on the length of credit history or the diversity of credit types, leading to a more pronounced or less noticeable score fluctuation. While a temporary dip might occur on one model, it could be less significant or recover faster on another. These differences in calculation explain why a consumer might see varying score changes when checking their credit score through different sources or using different credit monitoring services.