Do you know what sticks with you through the bad times closer than supportive family and friends? Creditors. It’s important to pay off your debts. Even then, no good deed goes unpunished either. So, how does paying off a loan payment hurt credit?
When you pay off a loan, especially a large loan, that is a significant part of your credit history being erased.
When you pay off a debt, your credit score may lower by some points. It doesn’t update automatically afterwards. It takes time.
Depending on your circumstances, it probably isn’t the end of the world.
Responsible credit utilization, and evidence of regular payments, are significant parts of your credit history. These are important metrics that determine credit scores.
Don’t close or cancel any credit accounts. Continue paying all outstanding balances in full and on time.
After paying off a large debt, your credit score may take a hit, but should normalize within a few weeks.
Though it sounds contradictory, its normal.
To better understand the problem, I’ll tell you why your credit score lowers after paying off a loan.
First, let’s discuss credit histories, credit scores, and payment histories.
What you don’t know about making responsible, full payments for large debts can be catastrophic to your credit score.
The average person owes $90,500 in personal debts. Debts are usually paid off incrementally, at least relative to how credit scores are calculated. If you pay off $90,500 in one or two payments, for example, a giant void would appear on your credit history. So, your credit score would be negatively affected temporarily as long as you have other credit accounts.
The Importance of Credit Histories
So, why does paying off a loan payment hurt credit scores?
Before we tackle that concept, you need to understand how credit scores work.
A credit score is three-digit number that denotes a level of creditworthiness to a creditor, credit card company, or lender.
The credit score was created by the Fair Isaac Corporation, also known as FICO.
A credit score ranges between 300 to 850. 800 to 850 represents a perfect credit score.
The average credit score is 695.
There are several credit scoring bureaus. But over 90% of financial lenders refer to FICO credit scores to make their creditworthiness determinations.
Your credit score is determined by 5 factors:
Credit Mix: This is the variety of debt you own which shows up on your credit history. A credit mix includes, but is not limited to, mortgage payments, car loan, credit cards, installment loans, bank loans, and so on. This activity comprises 10% of your credit score.
New Credit: This is a record of how often you apply for new credit and loans. This factors into 10% of your score.
Length of Credit History: From your first credit card to your latest, the length of your credit history is monitored. This comprises 15% of your score.
Credit Utilization Rate: This is the amount of credit you’re actually using compared to your credit limit. 30% of this metric determines your score.
Payment History: This is an exacting record of whether or not you pay your bills on time. This accounts for 35% of your overall score.
Now armed with this primer, it’s easier to ask the question:
How does paying off a loan payment hurt credit?
Pay Off Loan Payment, Hurt Credit?
Remember, it’s not the end of the world if your credit score lowers after making a loan payment.
It takes time for credit scores, which are calculated via complex mathematical algorithms, to recalibrate themselves.
Your entire credit history is being evaluated against one action.
However, the credit decrease won’t necessarily be temporary if you commit these actions.
Closing Credit Accounts
Whatever you do, don’t close a credit card account. Even if you’ve paid the debt in full.
There is a reason why your payment history accounts for 35% of your credit score.
This is the most important metric lenders and creditors review.
A credit history stretching back years or decades says a lot about your responsibility using credit cards.
When you close a credit card account, you create gaping holes in your credit history. If you close a credit card you owned for a decade, then a decade long gap in your credit history appears. How can your credit score not be affected?
Your credit score must be reevaluated by automated scoring algorithms against existing account histories minus the one that just disappeared.
That will cause a credit score drop.
Keep all credit accounts open. Make small charges regularly on accounts that are fully paid off, just to keep them active. This will protect your score.
The longer your account is active, the better off your score will be.
Paying Off Installment Loans
Installment loans can include car loans, a mortgage, student loan debt, and so on.
Once you pay off these debts, the corresponding account on your credit history will automatically close.
This in turn results in a decrease in your credit score.
When you pay off an installment loan, the payment history should remain on your credit history for several years.
Even after the account is closed, it won’t self-delete as it would if you voluntarily closed a credit card account.
In this situation, your credit score will dip. It should automatically normalize after a few billing cycles.
High Credit Card Utilization Rate
I haven’t owned a credit card in well over a decade.
When I was young, I used credit cards as a tool of finance in the same manner a nuclear weapon is used as a tool of war.
I used to max out credit cards and take out cash advances without considering the consequences for a moment.
If you do things like this, you can’t also be shocked when your credit score suffers.
If you use the majority of your credit limit for purchases, cash advances, or bill payments, the more financially irresponsible you’ll look to credit bureaus. Try to use 10% to 30% of any credit card at any given time.
Imagine if you have one credit card with a $1,000 credit limit. You charge $950 off your credit card every month and pack it back in full monthly too.
You now have a credit utilization rate of 95%.
The best option here is to reassess your budget and/or have multiple credit cards without exceeding a 30% utilization limit on each card.
If you don’t monitor your credit utilization rate, your credit score will dip.
Even if you responsibly pay bills on time and in full.
Vigilance Counts
So, why does making a loan payment hurt credit?
Closing credit card accounts creates glaring voids in your credit history.
Potential lenders aren’t going to contextualize the voids in your credit history when assessing your creditworthiness.
Paying off an installment loan, while responsible, will result in a momentary credit score dip.
And if you try to, “responsibly,” max out your credit card regularly, even if you pay it all back promptly, your credit utilization rate will increase. And, your credit score will dip.
In all of these scenarios, the dip is usually temporary. Your credit score is calculated by scoring algorithms.
It takes time for your score to normalize, which usually happens within a few billing cycles.
It pays to be informed on exactly how credit scores are calculated.
Whether bureaucratically fair or not, you may be the cause of your own credit score dip.
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Allen Francis was an academic advisor, librarian, and college adjunct for many years with no money, no financial literacy, and no responsibility when he had money. To him, the phrase “personal finance,” contains the power that anyone has to grow their own wealth. Allen is an advocate of best personal financial practices including focusing on your needs instead of your wants, asking for help when you need it, saving and investing in your own small business.