Whether you’re thinking about paying off a debt or mulling over how to increase your credit score — or both — it’s reasonable to ask if paying off debt helps your credit rating. The answer, though, is more complex than a simple yes or no.
We’ll delve into it all here, showing how paying off a debt can either raise or reduce your credit score, depending on the circumstances. We’ll also explain a bit about how credit scores are calculated, and especially how managing your credit utilization can give you some control over your credit score.
How Paying Off a Debt Is Connected to Your Credit Score
What affects your credit score is on a lot of people’s mind. Your credit score is determined by five factors, some of which are weighted more than others. Paying off a debt can affect each of these factors in different ways, causing your score to rise or dip. Sometimes changes in two factors can even cancel each other out, leaving your score unchanged. This is why it’s hard to predict how paying off a debt will affect your credit.
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Credit Score Calculation Factors
According to FICO® Score, a credit rating company, these are the five factors commonly used to calculate your score:
• Payment history (timely payments): 35%
• Amounts owed (credit utilization): 30%
• Length of credit history: 15%
• New credit requests: 10%
• Credit mix (installment versus revolving): 10%
Once FICO’s algorithm calculates your score, a credit score rating scale assigns it a category ranging from Poor to Exceptional. A higher number indicates to lenders that a person is a lower risk for default:
• Exceptional: 800 to 850
• Very Good: 740 to 799
• Good: 670 to 739
• Fair: 580 to 669
• Poor: 300 to 579
As you can see, a Fair credit score falls between 580 and 669. A Poor or bad credit score falls between 300 and 579. The minimum credit score required to qualify for a loan is around 610 to 640, depending on the lender — meaning not everyone with a Fair score would qualify.
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Why a Credit Score Can Go Down After Paying Off a Debt
Because paying off debt feels good and improves your financial situation, people can be surprised when their credit score actually drops. This negative impact can be due to changes in one or more factors:
• credit utilization
• credit mix
• overall credit age
When you pay off a credit card and then close the account, you reduce your available credit and increase your credit utilization. Similarly, if you pay off your only car loan and close that account, you have one fewer type of account in your credit mix. Finally, paying off and closing an older account may reduce the average age of your overall credit history. (We’ll explore these scenarios in more detail below.)
While none of these things is “bad” in financial terms, it temporarily counts against you in the world of credit scores.
What Is Credit Utilization?
Now for a little more background on credit utilization. Credit utilization is a factor with revolving forms of credit, such as credit cards and lines of credit, where you can reuse the account up to your limit.
Your credit utilization rate, or ratio, is determined by dividing the sum of your credit limits by the sum of your current balances. So if someone has a $5,000 limit and is using $2,500, that’s a 50% credit utilization rate. Your rate should be kept below 30% to avoid a negative affect on your credit score.
What Is a Credit Mix?
Lenders like to see that an applicant can successfully handle different kinds of credit. This includes installment loans like mortgages, car loans, and personal loans, as well as revolving credit such as credit cards and lines of credit. If a person can manage both types of credit well, a lender will likely consider them less of a risk.
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How Credit Age Factors In
The length of your credit history demonstrates your experience in using credit. To lenders, the longer the better. When payments are on time, this combo reassures lenders that you will likely continue to make on-time payments going forward.
New credit accounts can also lower your credit age. More important, opening or even applying for many new accounts is a red flag to lenders that you may be in financial trouble. The application process also involves a hard credit inquiry, which can lower your credit score.
Here are two examples of someone paying off a credit card. In one case, the credit score goes up. In another, it goes down.
Credit Utilization Goes Down / Credit Score Goes Up
Let’s say that someone has a credit utilization rate of 40%, which is negatively impacting their credit score. (Remember, below 30% is best.) When they make enough payments to bring their utilization rate down to 25%, this can boost their credit score.
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Credit Mix & Age Go Down / Credit Score Goes Down
Now, let’s imagine that someone pays off the balance of their first and only credit card. This should help their utilization score! But wait: Then they close the account, and their average credit age drops. And since this is their only form of revolving credit, their credit mix has lost out too.
Counterintuitively, paying off the card may make their credit score go down — at least in the short term.
Paying Off a Loan Early vs Paying It on Schedule
People often wonder if it’s better to pay off a loan early, if you can. In the case of a personal loan, early payoff can lower the average age of someone’s credit history, possibly lowering their credit score.
In reality, the effect will depend upon their overall credit situation. Paying the loan off according to the schedule will keep it open longer, which can help with their credit age. On the other hand, they’ll pay more in interest because the loan is still open.
If you’re in this situation, weigh the pros and cons before making the decision that’s best for you.
How Long Can It Take To See Your Credit Score Change?
According to the credit report agency TransUnion, credit reports are updated when lenders send them new information. In general, this happens every 30-45 days, though some lenders update more frequently.
If you’re concerned about your credit score, consider signing up for a credit monitoring service. What qualifies as credit monitoring varies from company to company. Look for a one that sends alerts whenever your score changes for better or worse.
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How paying off a debt affects someone’s credit score depends on the person’s overall credit profile. Paying off a credit card typically helps your credit score because the account remains open, lowering your credit utilization. Paying off a loan can hurt your score because the loan is then closed, potentially reducing your credit mix and age. Generally, though, borrowers shouldn’t let credit score concerns prevent them from taking actions that are in their financial interest.
To benefit from free credit monitoring and gain a bird’s eye view of your financial picture, try the SoFi Relay app. You can connect all of your accounts into one convenient mobile dashboard, set multiple financial goals, track your spending, and more — all in one place.
How fast does your credit score increase after paying off a debt?
In fact, your credit score may dip for a short period after a debt is paid off. Lenders report new information to credit reporting agencies every 30-45 days, though some lenders update more frequently. Generally, you shouldn’t let concerns about your credit score prevent you from taking action that is in your best financial interest.
Is it best to pay off all debt before buying a house?
Credit report agency Experian says it generally makes sense to pay off credit card debt before buying a home. Just know that in some circumstances, paying off a debt may temporarily reduce your credit score — which can affect the loan terms you qualify for. If you do pay off a credit card, keep the account open until after you qualify for a loan.
How do you get an 800 credit score?
Pay bills on time, maintain a credit utilization rate under 30%, and effectively manage your credit history length, new credit requests, and credit mix. Although this won’t guarantee a score of 800, it will help you maximize yours.
Photo credit: iStock/Patcharapong Sriwichai
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