You scrimp and save to pay off your credit card bill. You breathe a sigh of relief when your outstanding balance hits zero. And then you check your credit score. And suddenly, things don’t seem so bright and rosy anymore. Somewhere between paying off the balance and checking your credit score, something’s gone wrong. Your score is lower now than it was before. How is that possible? Your credit score reflects how well you manage your debt. If you’ve paid off a big balance, it should automatically improve, right? Unfortunately, no. While paying off the balance may improve things in the long term, it might not have quite the positive effect you were hoping for in the short term. To find out why, you’ll need to understand the various factors that impact your credit score.
Why Do I Have No Credit Even After I Paid off My Credit Card?
As bankrate.com explains, there are numerous factors that decide your credit score. Paying off debt may influence some, but not all. Your credit score covers a vast range of information, including the number of new credit inquiries you’ve made recently (every loan, credit card, or mortgage inquiry is noted, regardless of whether you ultimately proceed with the application or not), your payment history, your credit mix, your credit utilization, and the average credit account age. All of these individual pieces of information combine to create your overall credit score. As a result, there are various variables at work in deciding your credit score, even after you pay off a debt. Say you pay off a debt and close an account that’s been open for 15 years. The only other debt you have is against two fairly recent credit cards. By paying the debt and closing the account, you’ll effectively be reducing the average age of your accounts and lowering your credit utilization… neither of which spells good things for your credit score.
Understanding Your Credit Score
To understand why your credit score might drop after you pay off a balance, you need to understand how credit scores are calculated in the first instance. Scores are calculated against five key factors, all of which carry a slightly different weight. Payment history accounts for 35 percent of your credit score. Credit utilization accounts for 30%; the age of credit accounts for 15%; credit mix for 10%; and new credit for 10%. Not all of these variables will be affected if you pay off a balance, but several will.
Your payment history accounts for the biggest portion of your credit score. If you miss payments, your credit score will take a nose dive. If you pay off a balance, this aspect of your credit score won’t be affected.
Credit utilization is a fancy way of describing how much of your available credit you’re currently using. It’s the second most important factor after payment history in determining how your credit score is calculated. The lower your credit utilization, the better your credit score. As Experian notes, paying off a credit card balance lowers your credit utilization and is thus beneficial to your credit score. However, some people mistakenly believe that closing an account after paying off a balance in full will be beneficial. It won’t, at least not as far as your credit score goes. Closing an account reduces the amount of credit you currently have available and results in your overall credit utilization increasing. After a few months, this should right itself, but in the short term, it could explain why your credit score has dropped.
As per nerdwallet.com, part of your credit score (10% in fact) is determined by the types, or “mix,” of credit you have. If you have both installment accounts (ie. accounts which require defined payments over a specific period, as in the case of loans and mortgages) and revolving accounts (those with no set end date and varying payment amounts, such as credit cards), your credit score will be higher than if you have revolving accounts only. If you pay off and close an installment account while still holding credit card debt, your credit score is likely to take a dip.
Age of Credit History
The older your account, the more beneficial it is for your credit score. If you’ve paid off a balance on an older account and proceeded to close it, your credit score will take a hit, particularly if you have several new accounts still open.
Each time you apply for a new line of credit, the credit check is listed on your credit report. It typically remains on your history for around 2 years before dropping off. The more credit checks you run, the more adversely affected your score. If you made several new inquiries for credit after paying and closing off your previous account, it could explain why your credit score has dropped.
How to Avoid Lowering Your Credit Score
While paying off a balance and closing an account may feel satisfying, it’s not always the right thing to do for your credit score. Clearing debt is less important to a stellar credit score than making on time payments and optimizing your utilization rate. To avoid impacting your credit score detrimentally, be clever about how you pay off your debts.
Creditors like to see installment accounts over revolving accounts, so try to prioritize clearing personal loans and credit cards over student loans, car loans, and mortgages. As installment accounts usually have lower interest rates than revolving accounts, you’ll be saving on interest payments as much as you’ll be preserving your credit score. Secondly, check just how much credit you’re utilizing. If possible, it may be worth speaking to your provider about increasing your credit card limit: providing you don’t end up maxing out the card, you should be able to improve your credit utilization and get your credit score back up. Another option is to open another credit card. Although your credit card score will take a short term hit as a result of the hard credit check, in the long term, it’ll increase your total available credit and improve your score accordingly. Lastly, use your experience as a warning. Paying off a balance is all well and good, but closing the account might not necessarily result in the positive impact you were hoping for. In most cases, it’s preferable to pay off a balance but keep the account open, especially in the case of older accounts with a good payment history.