While it is commonly assumed that paying off debt will always result in a positive impact on one’s credit score, this is not always the case. In fact, sometimes paying off a debt will lead to a drop in the score which can be a damper if you don’t understand why.
Typically, your credit score is a result of more than just your payment history. There’s a formula that assigns a specific weight to each factor. The FICO score, used in making the majority of lending decisions, assigns 35% to payment history, 30% to outstanding debts, 15% to length of credit history, 10% to credit mix, and 10% to new credit.
Although paying off debt is a step in the right direction, it may not help improve your score immediately if you impact the credit mix, credit utilization, or length of payment history.
Below are possible scenarios why paying off debt didn’t improve your credit score
Interference with the Credit Mix
Credit mix refers to the different types of credit accounts you have, like credit cards, car loans, or mortgages. It’s important to have a mix of many accounts to keep your credit score healthy.
For example, having a credit card, a car loan, and a mortgage shows that you can handle different types of credit, which is a plus for your creditworthiness. However, if you pay off your credit card balance and close the account, your credit mix will be impacted because you’ll have one fewer type of credit account.
So, even though paying off your credit card debt is a good thing, closing the account could have a negative impact on your credit mix and, ultimately, your credit score.
Increased Credit Utilization Ratio
Your credit utilization ratio is the amount of credit you’re using compared to how much credit you have available. For example, suppose your credit cards have a combined credit limit of $20,000, and you owe $5,000, then your credit utilization ratio would be 25% ($5,000 ÷ $20,000).
Paying off your credit card balances usually boosts your credit score. However, it’s important to be aware that if you close a credit card account after paying it off, and continue to spend the same amount, your credit utilization rate could increase because you’ll have less available credit.
In this case, let’s say you pay off and close two credit cards with a total credit limit of $5,000. Your available credit will decrease to $15,000. If you utilize $5000, your credit utilization rate increases to 33% ($5,000/$15,000). This increase in credit utilization could potentially lower your credit score.
Reduced Length of Credit History
The length of your credit history is calculated using:-
- How long each of your credit accounts has been opened and their average age.
- The length of time since those accounts have been on your credit report.
- The last account activity.
The length of your credit history is an important factor in your credit score because it demonstrates your ability to manage credit over time. Lenders prefer borrowers who have a long and stable credit history because it indicates a lower risk of defaulting on loans.
So, if you pay off a debt and close an account, and especially if it happens to be one of your older accounts, it can potentially have a negative impact on your credit score because it reduces the average age of your accounts.
In Conclusion
Ultimately, paying off debt is one great move towards repairing your financial health. That said, you might not immediately notice the benefits where the credit score is concerned. Understanding how the factors outlined above affect your credit score will help you make better decisions and anticipate their results beforehand.
To help improve your credit score eventually, you need to prevent the entry of new negative information on your credit report. You can do this by paying your bills on time, keeping your credit card debt low, and avoiding new credit unless it is necessary.
