Why credit scores often drop after you pay off a loan
Paying off a loan can rebalance your credit data
- Credit mix is reduced
- Credit utilization rate increases
- Length of credit history shortens
- Payment history improves
It’s the moment you’ve been looking forward to for years: hitting submit on that final student loan payment. Before you can fully revel in your newfound financial freedom, you notice a drop in your credit score. What gives?
Conventional wisdom would suggest that if paying down a debt improves your credit score, then paying off a debt in full should be an even better boost, right? Not exactly. It is not uncommon for such a major credit action to slightly reduce your score. Think of it not as a penalty but a rebalancing of data. Credit scoring models weigh several factors in their calculations, and with one less loan and less available information for the scoring model to calculate, each of your active credit accounts and its associated history holds more weight.
Paying off a loan is a positive financial step that typically will not lower your credit score any more than 25 points. If you continue to pay other credit accounts on time without any other major credit activity, your score should recover quickly.
How credit scoring works
The three credit reporting bureaus – Experian, Equifax and TransUnion – each compile a credit report detailing your various credit transactions and repayment behavior. Credit reports list information, and are not a numerical figure. Scoring companies use proprietary algorithms to calculate a credit score from the information in these credit reports.
The FICO score — the most commonly used scoring model — calculates a credit score based on the following factors: payment history, which accounts for 35 percent of the score; amounts owed, accounting for 30 percent; length of credit history at 15 percent; new credit at 10 percent; and credit mix at 10 percent.
A closer examination of these factors illustrates how paying off a loan impacts your credit score in different ways.
There are two types of credit: revolving credit lines that you can draw from and repay repeatedly, such as a credit card; and installment loans, which carry a fixed amount, term and repayment schedule, such as an auto loan or mortgage. A mix of credit types improves your credit score, as it demonstrates the ability to responsibly handle different types of debt.
If you don’t have very many credit lines, paying one off can adversely affect your score. For example, if you have two consumer credit cards and a student loan, paying off the loan leaves you with a homogenous credit mix — just the credit cards. This can result in your credit score dropping a few points. If, on the other hand, you have a credit card, student loan and mortgage, your credit mix remains diversified even after paying off the student loan and your credit score should be affected to a lesser degree.
Your credit utilization rate — that is, how much you owe relative to the credit you have access to — has a major influence on your credit score. Having available credit and not spending it indicates a low-risk borrower in the eyes of scoring models.
If you’ve been consistently paying down a term loan like student debt, with each payment, your amounts owed falls against the initial loan balance, strengthening your score. When you pay off the term loan in its entirety, however, the credit line is no longer active. While this reduces your amounts owed, it also reduces the overall credit that was available to you, which can potentially hurt your credit score.
The degree to which paying off a term loan affects your credit varies by borrower. For example, if you have a student loan, an auto loan that is halfway through its term, and two credit cards that you rarely use, paying off your student loan shouldn’t have a major effect on your score. The amount of credit used remains low relative to your available credit.
If, however, you have a student loan, recently took out a mortgage and carry a balance on your credit card, paying off the student loan and closing that account results in less available credit and a higher usage rate. You still owe a considerable amount on your home loan and credit cards. In this situation, your credit score could fall more significantly.
Length of credit vs. payment history
Holding open, active credit accounts with a long history of consistent on-time payments strengthens your credit score. When you pay off a term loan, the line is no longer active and does not count toward your length of credit history. This can knock your credit score a few points.
The repaid loan will, however, remain in your past payment history for seven to 10 years. In this way, paying off the loan boosts your credit score by indicating that you’ve held, managed and repaid a term loan responsibly.