Your credit score may drop after you finally pay off debt, but it's only temporary

Tanza Loudenback

Jul 28, 2019, 19:45 IST

Your credit score may drop after you finally pay off debt, but it's only temporary

Your credit score may go down after paying off a loan or credit-card balance.
When you pay off an old loan and the account closes, the average age of your active accounts could drop, which has a moderate impact on your credit score.
When you pay off a credit-card balance, avoid canceling the credit card all together, because that can also affect the length of your credit history.
Ultimately, the long-term benefit of paying off debt outweighs any chance of a temporary hit to your credit score.
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Finally paying off debt that you've been chipping away at for months or even years feels really good.

But if you've ever been there, you know that wiping out a loan or big credit-card balance can temporarily lower your credit score. It seems like a cruel trick - after all, isn't debt the mortal enemy of excellent credit? It is, but there are a few more important factors in the mix.

While we don't know exactly how credit scores are calculated, the big credit-scoring agencies generally place importance on the same five factors. According to FICO, here's the breakdown:

35% payment history
30% current debt balances
15% length of credit history
10% new credit
10% credit mix

Closing an active account can have a negative impact on your credit

In addition to how much credit you're using and your ability to make on-time payments, the average age of your active accounts has an impact on your credit overall. The longer an account is open, the better it is for your credit score. If you consistently make on-time payments on longstanding accounts, you're probably in great shape, credit wise. Accounts includes not only credit cards, but any "installment loans" you currently have, including student, home, auto, and personal loans.

The difference between credit cards and loans is that when you pay off a balance on the former, your card remains active. When you make the final payment on a loan, however, the account will be closed. Herein lies the problem: If the oldest account on your credit report is a student loan you took out 10 years ago, that account will no longer factor in to the average age of your active accounts once it's paid off.

A temporary hit to your credit score is no reason to avoid paying off debt

Credit-scoring agencies also look at something called your credit mix, though it's usually not a determinant of your credit score. If you have five credit cards, a mortgage, and an auto loan, you have a good mix of different types of credit. Paying off one of those loans will reduce your variety of credit.

When it comes to credit cards, your credit utilization ratio has a very high impact on your credit overall. Credit utilization is the percentage of your total credit limit you're currently using. Experts recommend aiming for a credit utilization between 10% and 30%. When you have outstanding credit-card debt, that ratio is likely to be higher. But when you pay off your balances, it goes down.

Even if your credit score drops slightly after paying off a credit-card balance, it won't last for long. As long as you don't close the account all together and continue making on-time payments for any new balances, your score should neutralize, and ultimately rise, in no time.

All that said, anticipating a temporary hit to your credit score is no reason to avoid paying off debt. Current debt balances - including debt you owe and debt you pay off each month - account for some 30% of your overall credit score, so paying them off has a much greater benefit in the longer run. Plus, the longer you drag out your debt, the more you'll hand over in interest payments.