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Understanding Credit Score Changes After Paying Off Debt

Why Credit Scores May Drop After Paying Off Debt
Jason Steele
Jason SteeleUpdated March 14, 2023
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If you’ve paid off debt, you’re probably feeling pretty good about settling what you owed. However, you may also be surprised to see a drop in your credit score. This situation isn’t uncommon, but it can be confusing.Why does a credit score drop after you pay off debt? There are several reasons paying off debt can negatively impact your credit score, and it’s important to understand them. Read on to find out why your credit score may drop, and how you might help strengthen your credit again.

Why Did My Credit Score Drop After Paying Off a Loan?

There are a few possible reasons why your credit score dropped after paying off a loan. It could be because of your credit utilization, the average age of your accounts, the type of credit accounts you have, or other factors that affect your score. Here’s more about each one of them, and how they may impact your credit.

An Increase in Your Credit Utilization

Credit utilization is the portion of credit you’re using out of the amount of credit available to you. Ideally, you should aim to keep your credit utilization ratio low — around 30% or less. When you pay off a loan and close the account, the amount of credit you have available to you decreases. That could potentially cause your credit utilization to go up.

A Drop In The Average Age Of Your Accounts

The length of time your credit accounts have been open has an impact on your credit score. These accounts could be credit cards, a mortgage, a car loan, or personal loans. Generally, the older your accounts are, the better. For instance, if you have a loan that’s 10 years old and it’s in good standing — meaning you consistently make the payments due — it shows you can manage your debt. When you close an account that has been open for many years, however, it decreases the average age of your accounts overall. If the account was one of your oldest, or if you don’t have other accounts that are older than five years, that could be why your credit score dropped after paying off a loan. 

You Have No Other Installment Accounts

If you’re wondering, why did my credit score drop after paying off debt?, part of the reason could be the credit mix you have once the paid-off account is closed. It’s generally good for your credit to have a combination of both revolving accounts and installment accounts. A revolving account is one with varying payments and no specific end date, like a credit card. An installment account has set payments over a specific time, like a loan. If you close an installment loan after paying it off and then you’re only left with revolving accounts, it could cause your credit score to fall. 

Other Factors

If you see a significant drop in your credit score around the same time that you pay off a loan, there could be other factors at play. For example, if you applied for a new credit card or mortgage around the same time you paid off an existing loan, that could impact your credit score, too. 

Does Paying Off Debt Build Credit?

While paying off a loan can have a negative impact on your credit score, the drop is typically temporary. Paying off debt is a good thing because it could help improve your financial health overall. When you read your credit report, you may notice that once your paid-off account is closed, it eventually gets removed from your report. Accounts that were in good standing and were repaid in full may stay on your credit report for up to 10 years and positively impact your credit. Those accounts with marks against them, such as late or missed payments, a loan default or an account in collections, are removed from your credit report after seven years. So if you paid off your debt, and the account had a history of on time payments, that may help  positively affect your credit.

How Do Personal Loans Affect Your Credit Score?

There are many benefits to using a personal loan. With a personal loan, you get a lump sum of money that you can use for almost any purpose. For instance, you could take out a personal loan for home improvements, to pay medical bills, or to consolidate debt.It’s helpful to understand how applying for a personal loan may affect your credit score. When you apply, the lender will perform a hard credit pull to check your creditworthiness for the loan. A hard credit pull may negatively affect your credit score, and it can remain on your credit report for up to two years. Your credit score itself is also a factor when applying for a personal loan. Things like your score, your debt-to-income ratio, and your employment status can all impact your eligibility for a personal loan as well as the interest rate on the loan. It makes sense to explore different personal loans interest rates to see what you might qualify for.Once you have a personal loan, if you make your payments on time and in full, your credit score could improve. But if you miss payments or you’re late with them, your credit score may drop. If you run into financial troubles that make it difficult to repay a personal loan, speak to your lender about the possibility of deferred payments until you get back on your feet again. Deferred payments will not negatively impact your credit score, but missing payments could.

How Paying Off Your Loans Early Affects Your Credit

Most personal loans allow you to pay them off at any time. By paying off personal loans early, you can save money on interest. However, some lenders charge a fee for paying off your loan early, because they’re losing out on the interest. These are called prepayment penalties, and they can be a percentage of your outstanding loan balance. Check your loan contract to see if these penalties apply.In addition, repaying a loan early may have the same negative impacts to your credit score as paying off a loan on-time. However, if you are able to afford to repay the loan early, and your lender doesn’t impose a prepayment penalty, it may be worth it because you could save money on interest. 

Is It a Good Idea to Pay Off All Your Debt at Once?

In general, if you’re able to pay off a number of existing debts at once, you should do so. Maintaining debts just to avoid a negative impact on your credit is usually not worth the financial burden. Even if your credit score dropped after paying off a loan, it will eventually recover, and you may save yourself a lot of money in interest. 

The Takeaway

While paying off a loan may cause your credit score to drop temporarily, it’s usually a good idea to reduce the amount of debt you owe. Your credit score will recover, and you can save money on interest when you pay off your loans.If you’re looking for a new personal loan, you’ll want to shop for the best rates and terms you can get. Lantern can help. In our online marketplace, you can fill out one simple form and get offers from many different lenders at once. That way you can compare the options to find the right fit for you.

Frequently Asked Questions

Does it hurt your credit to pay off debt all at once?
Why is my credit score going down as I pay off debt?
Does paying off a loan early hurt a credit score?
Photo credit: iStock/Prostock-Studio

About the Author

Jason Steele

Jason Steele

Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.
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