Paying off a loan is a good thing. It’s a sign of success and responsibility. The logical conclusion from here would be that paying off a loan would help your credit score, but that’s not always what people experience.
Awhile ago, I saw a post on Reddit where a user said they saw their credit score drop after paying off student loans, and I wrote a story about that scenario. To sum it up: Paying off a loan is not in itself a negative thing in the eyes of most credit scoring formulas. Scores change constantly, and there are so many variables that the drop someone may see after paying off a loan could happen for a lot of different reasons.
But there’s more to it than that. After I saw a few comments from readers saying something similar happened to them, I dove deeper into the issue. I turned to the credit-scoring giant FICO to find out why some people report seeing their credit scores drop after paying off a loan, even though nothing else on their credit reports seemed to have changed.
Ethan Dornhelm, a senior director at FICO who oversees score development, said he could think of two situations in which paying off an installment loan would hurt someone’s credit scores. (Keep in mind this refers to FICO scores, of which there are many variations, and there are many more credit scoring models beyond FICO.)
1. You Paid Off Your Only Installment Loan
First of all, there are two kinds of credit: Installment loans (like a mortgage or student loan) and revolving credit (like a credit card or home equity line of credit). If the loan you paid off was your only active installment loan, you would likely see a small drop in your credit score. It has to do with your mix of active accounts, which is one of the five main factors that determine your credit scores.
“I would emphasize it’s the smallest of the five,” Dornhelm said. It makes up about 10% of your FICO score. “We found that those consumers who are demonstrating active and current responsible management of a variety of [accounts] show a lower risk.” By risk he means risk that the borrower will not repay creditors — that’s what credit scores assess.
To get those points back, you would need to have an active installment loan, i.e., borrow more money. It’s important to reiterate that account mix makes up a small slice of your credit score. Many financial experts would tell people to not go into debt just to improve their scores.
The other option is to compensate for those lost points. You could pay down credit card balances (you want to use as little of your available credit as possible) or be sure to pay loans and credit card bills on time. Payment history and credit utilization have the largest impact on scores (35% and 30% of your score, respectively).
2. Your Remaining Loans Have High Balances
Let’s say, for example, you just paid off your last student loan, and when you check your credit score, it went down a little bit. You have an open auto loan, so you know it’s not because of the account mix scenario described above. That auto loan could be the reason for the drop: If it’s a newer loan, meaning you haven’t paid off much of the balance yet, your credit report would show that you owe a significant portion of the original amount you borrowed.
This falls under that credit utilization category mentioned earlier.
“It’s one dimension of amounts owed,” Dornhelm explained, adding that “the key driver of that 30% of amounts owed categorization is your credit card utilization.”
He said that the difference between what you had owed on the loan before you paid it off and the balance of the remaining loans would have to be quite significant to impact your credit scores. Even then, Dornhelm said the drop would be small and temporary. The impact would probably be around 10 to 25 points or so, he said. A score change like that generally isn’t something to worry about, unless your score is hovering near two scoring thresholds, like between a good credit score and a great one. As you pay down your newer installment loans, you would likely see your credit score go up.
Of course, these things don’t tend to happen in a vacuum. It’s likely many things on your credit file are changing at once, so it can sometimes be difficult to pinpoint the precise impact one account is having on your credit score. You can get an idea of what’s going on with your free monthly credit report summary from Credit.com.
Dornhelm described the scenarios above as unique, adding that loan payoff tends to have a neutral effect on credit scores. That raises another common question: Why don’t people gain points as a direct result of paying off loans? Dornhelm said they could, in very specific situations, but for the most part, you can expect something anticlimactic. Regardless, reducing or getting out of debt is a huge accomplishment, and you should be happy about it.
More on Managing Debt:
- The Credit.com Debt Management Learning Center
- How to Pay Off Credit Card Debt
- 5 Tips for Consolidating Credit Card Debt
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