Paying off that large balance you carried for months on your credit card or making one last deposit toward your years of student loans is an unbeatable feeling. But more than just bringing you peace of mind, paying off your revolving and installment debts brings you closer to financial freedom.
Revolving credit (credit cards) is an extension of credit with an assigned spending limit but no end time to the loan, while installment credit(loans) offers borrowers a fixed amount of money over a specified period of time. No matter what kind of debt you owe, you typically have to pay interest on the outstanding balances. The sooner you can pay these debts off, the less money coming out of your pocket.
That said, acommon misconceptionis that paying off your debt always and instantly increases your credit score.It's true that getting rid of your revolving debt, like credit card balances, helps your score by bringing down your credit utilization rate. Yet, closing certain lines of credit can actually temporarily ding your credit score. Paying off your installment loans, which also includes things like car loans and mortgages, can sometimes have the opposite effect.
"It can be frustrating to see a drop in your credit score when you make a smart financial decision," says Amy Thomann, head of consumer credit education at TransUnion, one of thethree main credit bureaus.But before you get discouraged, know why it happens and how much it matters in the long run.
According to Experian,another credit bureau, there are a few reasons why your score may drop when you pay off an installment loan.
- You paid off your only installment account:Lenders like to see that you can manage a variety of different types of debts. Considering your mix of credit makes up 10% of your FICO credit score, paying off the only line of installment credit can cost you some points.
- You paid off your lowest balance account: The outstanding balances across all of your open credit accounts, or your amounts owed, makes up 30% of your credit score. If the installment loan that you paid off had the lowest balance, thus bringing down the average amount owed and leaving your only remaining active accounts with high balances, your credit score may drop.
- Something else happened: Though you paid off an installment loan and immediately saw your credit score decrease, it could just be a mere coincidence and something else caused your credit score to drop. Remember that a bunch of factors impact your score, such as applying for a loan or new credit card or racking up a high credit card balance in the meantime.
If you do experience a dip in your credit score when paying off an installment loan, know that it is likely small and only temporary.
Why you should still aim to pay off your debts anyway
Just because paying off an installment loan could ding your credit score, don't keep it open just for the sake of maintaining a high score.
You wouldn't want to pay unnecessary interest over time just to save a few points, and your 3-digit score can bounce back. The average credit score recovery time after closing an account (for those with poor to fair credit) is three months, according to Bankrate. Making a series of monthly on-time bill payments is the fastest route to improving your score. (Payment history is the most important factor.)
"Remember: your credit score is just one piece of your overall financial health,"Thomann says, emphasizing the importance of reducing interest and overall debt. "That you're making the effort to actively engage and take control of your credit health makes it more likely you'll reach your financial goals over time."
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FAQs
Paying off your only line of installment credit reduces your credit mix and may ultimately decrease your credit scores. Similarly, if you pay off a credit card debt and close the account entirely, your scores could drop.
Can paying off debt hurt your credit score? ›
For some, paying off a loan won't affect credit scores much at all. For others, it may cause a temporary drop. This can happen if it was your only installment loan, since having a mix of different types of accounts helps your score, and losing your one installment account can bring it down slightly.
Why did my credit score drop 40 points after paying off debt? ›
If you take out a loan to consolidate debt, you could see a temporary drop because of the hard inquiry for the new loan. Your credit score can take 30 to 60 days to improve after paying off revolving debt. Your score could also drop because of changes to your credit mix and the age of accounts you leave open.
Is there a downside to paying off debt? ›
Less discretionary spending money
Whether you're paying off a loan with a lump sum or you plan to chip away at it with larger payments, paying off your loan faster will likely mean tightening up your budget.
What is the most damaging thing you can do to hurt your credit score? ›
Making a late payment
Your payment history on loan and credit accounts can play a prominent role in calculating credit scores. Even one late payment on a credit card account or loan can result in a credit score decrease, depending on the scoring model used.
How can I pay off my debt fast without hurting my credit score? ›
While you can't avoid all hits to your credit score when consolidating debt, you can minimize the impact and repair damage faster with these tips:
- Stop using your credit cards. ...
- Pay your bills on time. ...
- Keep credit lines open whenever possible. ...
- Avoid opening new accounts for a while.
While the answer varies on a case-by-case basis, it's often important to strike a balance between the two. Wiping out high-interest debt on a timely basis will reduce the amount of total interest you'll end up paying, and it'll free up money in your budget for other purposes.
Is 650 a good credit score? ›
As someone with a 650 credit score, you are firmly in the “fair” territory of credit. You can usually qualify for financial products like a mortgage or car loan, but you will likely pay higher interest rates than someone with a better credit score. The "good" credit range starts at 690.
How to get 800 credit score? ›
Making on-time payments to creditors, keeping your credit utilization low, having a long credit history, maintaining a good mix of credit types, and occasionally applying for new credit lines are the factors that can get you into the 800 credit score club.
How to raise your credit score 200 points in 30 days? ›
How to Improve Your Credit Score
- Review Your Credit Reports. The best way to identify which steps are most important for you is to read through your credit reports. ...
- Pay Every Bill on Time. ...
- Maintain a Low Credit Utilization Rate. ...
- Avoid Unnecessary Credit Applications. ...
- Monitor Your Credit Regularly.
The 50-30-20 budget rule states that you should spend up to 50% of your after-tax income on needs and obligations that you must have or must do. The remaining half should dedicate 20% to savings, leaving 30% to be spent on things you want but don't necessarily need.
How aggressively should I pay off debt? ›
Pay the largest or highest interest rate debt as fast as possible. Pay minimums on all other debt. Then pay that extra toward the next smallest debt. Paying off a big debt can boost a feeling of control and gets rid of big interest, too.
Is it bad to pay off debt all at once? ›
If you can afford to pay of your debt quickly, do it! Not only will it improve your credit utilization score, but it will save you hundreds if not thousands in interest.
What is the number one credit killing mistake? ›
Not Paying Bills on Time
Your payment history is the most influential factor in your FICO® Score, which means that missing even one payment by 30 days or more could wreak havoc on your credit.
What is the biggest killer of credit scores? ›
The five biggest factors that affect your credit score are payment history, amounts owed, length of credit history, new credit, and types of credit. To improve your credit, it's important to understand how these factors impact your credit and what a credit score means when you apply for a loan.
What 5 things do credit score experts want you to know? ›
Five things that make up your credit score
- Payment history – 35 percent of your FICO score. ...
- The amount you owe – 30 percent of your credit score. ...
- Length of your credit history – 15 percent of your credit score. ...
- Mix of credit in use – 10 percent of your credit score. ...
- New credit – 10 percent of your FICO score.
If you're close to maxing out your credit cards, your credit score could jump 10 points or more when you pay off credit card balances completely. If you haven't used most of your available credit, you might only gain a few points when you pay off credit card debt. Yes, even if you pay off the cards entirely.
Can paid off debt be removed from credit report? ›
Even after you pay a collection account, it stays on your credit report for seven years. However, you can dispute collection accounts that are inaccurate. You may even be able to persuade a collection agency to remove the account once you've paid it.
Why is my credit score going down when I pay on time? ›
Using more of your credit card balance than usual — even if you pay on time — can reduce your score until a new, lower balance is reported the following month. Closed accounts and lower credit limits can also result in lower scores even if your payment behavior has not changed.
