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Published on June 2, 2014
When trying to get your financial life on track, the No. 1 thing experts recommend is to pay off your consumer debt. Not only does this free up money each month, but it should improve your credit score, right? Not necessarily. Here’s why.
I paid off all of my debt, and my score to dropped — why?
If you paid off your debt in the hope that your credit score would flourish, you may be disappointed. To understand why, we need to look at the five factors that go into a credit score.
- Payment history (35%): Paying all of your bills on time, every time is the best thing you can do for your score.
- Credit utilization (30%): Keeping your debt-to-credit ratio below 30% is important.
- Length of credit history (15%): The longer you’ve kept your average credit account open, the better.
- Types of credit in use (10%): A healthy mix of different types of credit, like credit cards, student loans and a mortgage, can help your score.
- New credit (10%): Applying for new credit accounts will initiate a small hit to your credit.
The second-most-important factor, credit utilization, is the reason why your credit may drop a little after you pay off your debt. While having low credit utilization is good, having no credit utilization may be harmful to your score.
I don’t want my
credit score to drop — what should I do?
It’s possible to keep a low revolving amount of credit by the bureaus’ standards without paying any interest. By using your credit regularly, and paying it off in full each month before the due date, it will show that you’re utilizing a small percentage of your credit.
If your low credit score is a product of past mistakes or present disorganization, you need to get in the habit of making good credit decisions. Here are a few things you need to do to increase your score:
Make all of your payments on time. Think you can coast now that your debt is gone? Think again. While on-time payments typically can’t help your credit, paying medical and utility bills late can hurt your credit if reported. If you can’t remember to make payments, automate them. Just make sure you’re getting every bill paid on time every month.
Check your credit report for errors. Any attempt to build your credit will be fruitless if the data going into your score is wrong. Each year, you can pull your three credit reports for free. Look them over to make sure your reports are accurate by following our guide to reading your credit report .
Hold off on applying for more credit. New credit applications lower the age of your average credit account and initiate a new credit penalty. Refrain from applying for new credit for now.
Practice patience. Sometimes the best thing you can do for your credit is wait. A combination of patience and good habits will help any credit score bounce back.
Should I really be that concerned about my credit score dropping?
If your credit score dropped by a negligible amount when you paid off your debt, you likely don’t need to worry. Here’s a secret for you: You don’t need a score of 850 to get the best terms. However, you should aim for a credit score over 720. Anything over that is excellent, and dropping from an 810 to a 790 won’t hurt you when it comes to favorable credit terms.
Bottom line: Your credit score may drop a little when you pay off your debt. If you still have an excellent score, it’s nothing to worry about. But if you do need to work on your credit, make sure to make your payments on time, check your credit reports annually and be patient.
Question image via Shutterstock