Don't worry, it is very rare that paying off a personal loan will cause your score to drop, but it does happen every so often.
Wait a minute, did you read that title right? Paying off a personal loan might lower your credit score?
Unfortunately, it is indeed possible. Thankfully, it’s far from the norm. We’ll reiterate this point later on, but paying off your debts is almost always going to help your credit score.
So if you only take one thing away from this article, it’s that you should pay your bills on time and in full.
OK, now let’s actually address the question.
But first, let’s go over credit scores.
If you’re a regular reader of the Financial Sense Blog, you probably already know the factors that make up your credit score inside and out. But this could be someone’s first financial article ever! So we’ll just do a quick run-through.
The three major credit bureaus, Experian, TransUnion, and Equifax collect financial information which is used to generate your FICO credit score. FICO scores are a number between 300 and 850. The higher the score, the better loans you’ll be able to access and at better rates.
There are five factors that go into your credit score. In descending order of importance, they are:
- payment history
- amounts owed (also known as credit utilization)
- the length of your credit history
- credit mix
- new inquiries
Want a more in-depth break down of each of those factors and the activities you should pursue to positively affect them? Well, then we’ve got an article for you!
Pretty much never.
As we made clear in the opening paragraph, paying off your loans is almost always going to have a positive effect on your credit score.
“Paying off your credit card or loan will never negatively impact your credit score,” advised Mike Pearson, founder of personal finance website Credit Takeoff. “In fact, making on-time payments on your accounts is actually the single most important factor when it comes to calculating your credit score. So where does this misconception come from?
“I believe it’s when you pay off a credit card completely … and then close the account. When you close a credit card, it can end up hurting your credit score because you have just lowered the amount of available credit you have, which will increase your credit utilization, which is the second most important credit score factor.
“Generally, you want to keep a credit utilization under 30 %. For example, say you have two credit cards, both with a $5,000 limit, and your credit card balance is $2,500. Since your balance is only 25% of your total available credit between your two cards, you are in good shape. However, look at what happens when you close one of those credit cards.
Suddenly, your total available credit is only $5,000 in total. And if you have a $2,500 balance, your credit utilization has just doubled to 50%. In this instance, your credit score will definitely drop as a result of having a high credit utilization.
“In short: paying off your credit card will never hurt your score, only when you close the card for good.”
So that’s the story with credit cards. But perhaps there are some instances where paying off an installment loan will have a negative impact on your credit score?
But not quite never.
There are actually a few instances where paying off a loan may have a somewhat negative impact on your score.
“In general, paying down a balance will help your credit rating,” explained Todd Christensen, education manager for Money Fit by DRS, Inc. “Paying it off is even better. That said, there is some gray area where some balance payoffs may not help much if at all. This is particularly true for old collection accounts that are about to fall off your credit report or already have.
“If the debts are no longer reporting to your credit (in theory, seven years from the last time your account changed status, such as from on time to late or from late to paid as agreed, though in practice seven-and-a-half years is what you can expect), they have no impact on your credit rating.
“By paying them down or off, you are possibly changing the reporting status form late or default to paid, which could restart the seven-year reporting period. But such accounts, even though paid, would still report for those seven years as a collection or charged off account, albeit with a $0 balance.
“Paying a balance down to $0 is one of the best things you can usually do to build or rebuild your credit. After keeping your account status in the ‘paid as agreed’ range, lowering your account balances should be your next priority.
“It is not an easy choice. Most people want to pay off or down their debts. In cases of very old debts, doing so can complicate, if not damage, your credit rating. It never hurts to ask the collection agency or creditor holding your old debt to accept the payment but not to restart the credit reporting period. Just getting it in writing.”
Dave Sullivan, vice-president of marketing for the People Driven Credit Union reiterated that paying off a loan can occasionally lower your credit score and urged the always important advice of looking at each instance on a case-by-case basis:
“Paying an installment loan off can also reduce a credit score if there are no other installment or mortgage accounts on the credit history. As with all credit advice, it depends on the individual’s credit profile.”
There’s also the issue of student loans. While paying off your student loans is, of course, something to be celebrated, it’s not unlikely that doing so will cause a hit to your credit score. We’ve actually covered the phenomenon previously.
So to sum up, you should pay off your debts. Just know there is a chance your credit score could go down and plan accordingly if necessary.
Author and Accredited Financial Counselor®, Todd R. Christensen, MIM, MA, is Education Manager at Money Fit by DRS, Inc. (@MoneyFitbyDRS), a nationwide nonprofit financial wellness and credit counseling agency. Todd develops educational programs and produces materials that teach personal financial skills and responsibilities to all ages. Having facilitated nearly two thousand workshops since 2004 on the fundamentals of effective money management, he based his first book, Everyday Money for Everyday People (2014), on the discussions, tips, stories and ideas shared by the tens of thousands of individuals and couples in attendance.
Mike Pearson is the founder of Credit Takeoff, a research-driven personal finance site for people looking to improve their credit. A proud member of the 800 Credit Club, Mike writes about practical steps that everyday consumers can take to increase their credit scores. His advice on credit repair and credit scores has appeared in QuickBooks, Go Banking Rates, and MortgageLoan.com.
Dave Sullivan is the VP of Marketing for People Driven Credit Union. He started in the mortgage industry as a loan officer in 1991. Less than one year later started selling credit reports to Mortgage Companies, Banks and Credit Unions. On September 19, 1997, he started AIR Credit Midwest out of his car. Over the next two years, Air Credit Midwest grew to a multi-million dollar company. In 2000, He sold Air Credit Midwest to one of the largest credit reporting bureaus. In 2011, Sullivan started a YouTube channel providing free advice on improving your credit. He is the author of the book Transform Your Credit.
Andrew Tavin is a writer, comedian, and a full-time content manager for OppLoans. He graduated with a BFA in TV Writing from Tisch School of the Arts in New York City, worked as a writer for BrainPOP, and created a branded comedy video series for the National Retail Federation called “Interview Day.” He performs around the country and his writing has also appeared on Collegehumor, Funny or Die, and Sparklife.
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The information contained herein is provided for free and is to be used for educational and informational purposes only. We are not a credit repair organization as defined under federal or state law and we do not provide "credit repair" services or advice or assistance regarding "rebuilding" or "improving" your credit. Articles provided in connection with this blog are general in nature, provided for informational purposes only and are not a substitute for individualized professional advice. We make no representation that we will improve or attempt to improve your credit record, history, or rating through the use of the resources provided through the OppLoans blog.