Why Paying Off a Loan Can Lower Your Credit Score

You just sent that final payment in and requested the account to be closed. “Good riddance!” you’re thinking to yourself. Then, when you pull your credit report and request a score quote a few weeks later you’re stunned to discover your credit score has dropped. Confused — and more than a bit irritated — you contact the credit reporting bureau only to learn paying off the account is the reason it happened.

But how can that be?

Shouldn’t paying the account in full have made your score go up?

Here’s why paying off a loan can lower your credit score.

 

How Credit Scores Are Calculated

According to the experts at Fair Isaac Corporation, credit scores are computed based upon the following data:

  • Payment history (35%)
  • Amounts owed (30%)
  • Length of credit history (15%)
  • New credit (10%)
  • Credit mix (10%)

Transaction information reported to the credit bureaus is compiled to determine how you fare in terms of the above categories. Each is weighted based upon its relative importance. As you can see, payment history and amounts owed (also known as credit utilization) are the most prominent factors. The age of your credit accounts and your credit mix can also come into play in this scenario, as we will explain below.

 

Amounts Owed/Credit Utilization

Lenders get concerned when your credit utilization trends above 30 percent of the total credit available to you. This is calculated both in terms of the overall amount of credit issued on your behalf as well as the balance owed on each of your accounts relative to that account’s limit. Here’s the thing, though: If credit utilization comes in at zero on an account, it could cause your score to dip slightly.

 

Length of Credit History

Another way paying off that loan may have affected your credit score negatively is in the overall length of your credit history. Paying an account in full and closing it means it will not appear on subsequent reports. If that account happened to be the one you’ve had the longest and all of your others are quite young in comparison, your credit history can appear artificially short.

A longer history of strong performance raises your score. A shorter history, regardless of your performance, diminishes it comparatively. This can also come into play with a debt management program as they can require you to close some accounts. It’s important to consider the effect this will have on your score when you’re choosing which accounts to close, rather than shutting them down randomly.

 

Credit Mix

Similarly, the types of accounts you have open will figure into your score as well. Paying off an installment loan, like a car loan or student loan, can help your finances but might ding your score because it typically results in a narrower variety of accounts. You’ll see a downtick in your score If you inadvertently upset your credit mix by closing an account.

 

Don’t Worry About It

Hold up a minute, though. Before you think the system is designed to keep you indebted forever, it’s important to note these drops are usually minimal. Moreover, carrying debt just to buoy your credit score really doesn’t make sense.

Now that you know why paying off a loan can lower your credit score, you can minimize its impact by doing so strategically. Further, given the length of your credit history accounts for 15 percent of your score, if you simply avoid closing old accounts, you will likely sidestep this issue altogether.

The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.