No one wants to have debt, but sometimes it’s the only way to get by, even when it’s the last thing someone wants. This is why it’s such a relief when you’re able to pay off a debt; it’s a load off your shoulders. Unfortunately, while it is an accomplishment to pay off a debt, it doesn’t necessarily mean that it will positively affect your credit score. In some cases, it can actually cause your credit score to drop, as counterintuitive as it may sound. To understand why your credit score may drop after repaying debt, it’s necessary to understand the factors that make up your credit score.
Why Does a Credit Score Drop After Repaying a Debt?
Creditors want people to repay the money they lend; therefore, it’s reasonable to assume that paying off debt helps a credit score rise. However, that’s not exactly how a credit formula works. The portion of your credit limit that is currently in use is known as credit utilization and is a significant factor in a credit score.
Credit utilization is one of the reasons a credit score may drop after paying off some of your debt (especially if an account is closed). It’s ideal to have low credit utilization—30% or lower. The lower, the better. Low credit utilization shows lenders that you can manage your finances without relying too heavily on credit. When you pay off debt and close the account, the amount of credit available to you decreases, which results in your overall utilization going up and, in turn, dropping your credit score.
Other factors that are considered in the credit score formula that can also contribute to your score dropping after paying a debt include:
Average Age of All Opened Accounts
Another component that is considered in the calculation of your credit score is the length of your credit history. Paying off an old debt may short your credit history and make it appear as if you don’t have a long credit history to lenders, which can cause your score to drop.
Credit Mix
Credit companies want to see a credit history demonstrating that you’re using several different types of credits responsibly. When you pay off a loan or close an account, this may affect the variety of your credit mix, which can cause a temporary drop in your credit score.
Paying off debt is a positive accomplishment, and it shouldn’t negatively impact your credit score. While it may seem complicated, paying off debt doesn’t necessarily have to cause a drop in your credit score. This is why it’s important to understand the many components that make up your credit score and how to pay debt to help your score increase, not drop.
How to Pay Off Debt and Help Your Credit Score
Prioritizing credit card debt can help you budget because cards generally have higher interest rates than installment loans. Tackling your credit card debt first can also help lower your credit utilization score if you find you use one card or certain cards the most. Cards that are close to their limits should be a priority. The goal is to lower those balances to no more than 30% of your limit (once again, the lower, the better).
Other credit-building habits to keep in mind:
- Pay on time, every time
- Keep credit cards open (if possible)
- Use credit lightly
- Try not to keep installment loans just to avoid a score drop—this can lead to unnecessary interest cost
Paying off debt is rarely the wrong decision, especially if it has a high-interest rate. This is true even though it may cause a temporary drop in your credit score.
Need Help With Your Debt? Consult a Debt Settlement Attorney
You are not alone if you are struggling with debt and unsure how to best approach tackling your payments. Nearly everyone has some form of debt, credit cards, student loans, personal loans, and many more, yet not everyone has the financial knowledge to tackle their debt problems.
At McCarthy Law, our attorneys are dedicated to helping you get out of the cycle of debt. We know that a lot of the language surrounding debt is deliberately confusing, and we are here to make you feel more confident in your decision about debt by providing you with the legal knowledge and support you need. Our licensed attorneys can handle negotiating with lenders to reduce interest rates and balance of your credit cards. Contact our offices at (855) 976-5777 or complete our contact form to speak with one of our skilled debt settlement attorneys today.