Why Did My Credit Score Drop After Paying off Debt?

When making that final payment on a loan or other source of debt, you’ll feel a sense of pride and accomplishment. If you see your credit score fall a bit after making that final debt payment, you’ll probably feel less pride and more confusion. 

Many consumers are often shocked to find that their credit score may drop after making their last payment. By educating yourself about how credit scores are calculated, you’ll be better equipped to deal with this scenario. In this article, we’ll outline the reasons that can cause your credit score to drop after you pay off debt, along with steps you can take to bring your score back up.

Reasons Why Your Credit Score Dropped After Paying Debt

Paying off debt and closing an account can impact your credit utilization rate, your credit history, and your credit mix, which are all factors that impact your credit score. Canada’s credit bureaus (Equifax and TransUnion) use a specific formula to calculate your credit score. This formula is based on five main factors that each contribute a certain amount to your overall score: 

• Payment history (35%)

• Credit utilization (30%)

• Credit history (15%)

• Credit mix (10%)

• Credit inquiries (or applications for new credit) (10%)

Your overall score is a blend of these different factors. Paying off debt can positively affect one factor (such as your payment history) while temporarily hurting another factor (such as your credit history or credit mix).

Paying off debt and closing an installment or revolving credit account can temporarily impact the following factors that make up your credit score:

• Credit utilization: Fully paying off a credit card or line of credit won’t hurt your credit score, but closing that credit account can cause your overall credit utilization rate to increase, temporarily hurting your credit score

• Credit history: When you fully pay off a source of debt you’ve had for a long time (like a mortgage) it can impact your credit history and temporarily reduce your credit score

• Credit mix: Fully paying off a loan may decrease your credit mix and can cause your score to temporarily decrease

Here’s a closer look at how each of these scenarios plays out.

Closing an Account Impacts Your Credit Utilization Rate

Your credit utilization rate is how much credit you are using compared to the total amount of credit (or credit limit) available to you from revolving credit accounts. For example, let’s say I have two credit cards, and each card has a credit limit of $1,000. If I’ve spent $500 on one credit card and $0 on the other card, I would have a credit utilization rate of 25% ($500 divided by $2,000, multiplied by 100). 

Credit bureaus prefer that you use 30% or less of your total credit. Essentially, you need to avoid maxing out your credit cards and lines of credit. 

Paying off credit card debt won’t directly impact your credit utilization rate. However, if you decide to cancel a credit card, you may end up reducing your total credit limit, which will cause your credit utilization rate to increase and impact your credit score. 

Take the example above. If my $500 balance remains the same, but I decide to close the credit cards that has a $0 balance, my total credit limit would decrease from $2,000 to $1,000, and my credit utilization rate would increase from 25% to 50% ($500 divided by $1,000, multiplied by 100). Sudden increase to your credit utilization rate can cause your credit score to decrease.

Paying Off Debt can Reduce Your Credit History 

Credit bureaus also find the length of your credit history, including average age of your debt accounts, to be an important factor of your score. When you fully pay off a source of debt, that account will be removed from your credit report, which can cause the average age of all of your accounts to decrease.

Paying off debt or closing a credit account will reduce your overall credit history and can temporarily impact your credit score. The older the credit account is, the more noticeable an impact it can have on your credit score. The credit score impact from paying off debt, however, is often temporary, so you shouldn’t be dissuaded from fully paying off a loan or mortgage when possible. 

You should, however, aim to keep revolving credit accounts (like credit cards or a line of credit) open even if they have no balance, as canceling a credit card can impact your credit score but is avoidable.

Paying Off Debt can Impact Your Credit Portfolio Diversity

Your credit mix is another key credit score factor. Scores tend to be higher when you have both installment accounts (a loan for example, where you pay set payments over time) and revolving accounts (variable payments and no determined end date, like a credit card). If you close an account and one of these types of credit disappears from your credit report, it may cause your score to decrease.

Maintaining multiple types of debt is important to keep a healthy credit score. By paying off a piece of debt that makes your credit report less diverse, it can lower your score. A good example of this is paying off an individual loan and being left only with credit cards. The end result is a less diverse mix of debt and your score may go down temporarily.

Because your credit mix only accounts for 10% of your overall credit score, the impact of paying off a loan will often be short-lived. As a result, you shouldn’t be hesitant about paying off a source of installment debt, as your credit score will recover over time.

How Are Credit Scores Determined?

Generally speaking, there are five main areas that go into building your credit score. They are: payment history, credit utilization, credit history, credit mix, and credit inquiries or applications for new credit.

Payment History

Payment history impacts the largest portion of your credit score. Not making a payment or defaulting on a loan will cause your score to plummet. Make sure you understand your cash flow and how to calculate it to ensure your payments arrive on time.

Credit Utilization

Credit utilization is the next largest slice of your score. The amount of credit you use is calculated by dividing your balances by your total debt limit.

Credit History

This factor is not as important as the previous two, but it can still have a big impact on your credit score. Keeping older accounts has benefits, and opening too many new accounts all at can be a negative factor.

Credit Mix

Credit Mix plays a smaller role in your credit score, but it is still important. Credit bureaus, as well as lenders, prefer a mix of both installment loans and revolving credit. 

Installment loans, like mortgages and car payments, have set payments and a set time where they must be paid off. 

On the other hand, credit cards are called “revolving debt” because the payment varies monthly and lacks a repayment period. 

As a result, paying off a mortgage without having another installment loan available, might cause your score to drop.

New Credit

Lastly, are credit inquiries. Many lenders are approving new credit cards, but applying for a new credit card can impact your score. New credit inquiries stay on your credit report for two years. These inquiries sometimes result in your score dropping for a brief period. 

Does Paying Off Credit Card Debt Impact My Credit Score?

Paying off a credit card is a great way to reduce monthly payments and reduce your credit utilization. Paying off a credit card will make your remaining balances a smaller percentage of your overall credit limit and thus help your score.

You should aim to pay as much of your credit card balance as possible each month in order to keep your credit utilization rate low and avoid interest charges for future payments.

Should I Keep a Credit Card Open After I've Paid It Off?

Yes, even if you’ve paid off a credit card in full, you should keep the credit card account open in order to keep your overall credit limit high and credit utilization rate low. Canceling a credit card can cause your credit score to quickly drop. 

Paying off credit card debt in full can be a great feeling. You may be tempted to close a credit card account after you’ve paid a debt in full and no longer use the card regularly. But closing the account that you’ve paid off will cause you to lose that account’s credit limit and thus increase your overall credit utilization ratio. 

What this means is that sometimes it’s better to keep a credit card open with a small balance. Make small purchases each month (such as coffee or a regular streaming service) to keep the credit card account open with a minimal balance.

When Will My Credit Score Go Up After Paying Off Debt?

Credit scores update infrequently. Sometimes it can take at least two months for debt payment information for your score to update.

Does Applying For a New Loan Affect My Credit Score?

Once you’ve paid off debt or closed a line of credit, you might start thinking about applying for another loan or finding a new credit card. Remember, your blend of credit types as well as your credit utilization impact your credit score, so increasing your amount of available credit can actually help your score. 

However, every time you apply for new credit, and the creditor runs a hard credit check, that inquiry becomes listed on your credit report. Each time a hard credit check is added to your credit report, it can negatively impact your credit score.

How Long After Paying Off a Loan Can I Borrow Again?

Sometimes it’s better to wait a while to open a new line of credit after paying off a debt. When you apply for a new credit account, creditors will note a hard inquiry onto your credit report. Additionally, opening a new credit account will also lower the average age of your credit accounts. Best practices indicate that you should wait at least six month between submitting applications for new credit. In this case, being patient can benefit your score in the long run.

How Can I Improve My Credit Score Once I Have Paid Off My Debts?

Once you have paid off your debts, you will probably want to know how to improve your score. First and foremost, paying off your debts is almost always a good decision. Credit cards and other types of consumer debt frequently come with high interest rates, so paying them off helps your financial well-being. 

After your debt is paid, the best approach to take is to keep making other bill payments on time and keep your overall credit utilization under 30%. Payment history and credit utilization are the largest factors that impact your credit score by far, so if you focus on these two factors, you’ll see your credit score recover from a temporary credit score drop in a short amount of time. 

If you’re concerned about your credit score dropping after paying off debt, don’t sweat it. This credit score impact is usually temporary, and as long as you keep exhibiting good credit and financial behaviour, your credit score will go back up to its normal level over time.