Why does credit score drop after paying off a loan?
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The point of a credit score is to determine the risk of you not paying back a loan on time. Legally, credit score is not allowed to include your income or employment status. However, those are obviously important factors in determining your credit risk.
Their kludgy workaround is to use your monthly debt payments to extrapolate what your income might be that month. When some or all of that debt payment goes away, their calculations get thrown off and they lower your score to account for the (small) chance that you lost income that month. After a few months of on-time payments on your remaining loans, they realize that you never lost income and your score recovers.
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Credit scores factor in a lot of things like the average balance of your accounts, average age of your accounts, payment history, etc. If you’ve opened up new accounts and paid off a loan you had for a very long time, it can hurt your credit score because you don’t have a long payment history on your current accounts. It makes it look like you’re a riskier debtor. Credit scores also reward you for having a mix of revolving accounts which are accounts like credit cards which don’t have set payment schedules and installment accounts which are accounts with a fixed loan amount that you pay a set minimum every month. If you close an installment account and all your remaining accounts are credit cards, it looks bad to a creditor.
Credit scores are calculated based on the number, kind, age, and mix of the various accounts you have (loans + credit cards + savings/checking). If you finish a loan:
* You have one less account (and its history) contributing to your score.
* You have a less diverse portfolio
* The average age of your accounts decreases
* Your credit utilization (ratio of currently used credit / max credit) increases because your max credit went down. (For some reason, it looks good if you have a huge credit limit that you’ve barely used, like if you have a credit card with a high limit but you NEVER max it out. Loans count as increasing your max credit limit while you have them.)
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Every discussion about credit scores needs to be prefaced by pointing out two things:
* Credit scores do not exist for the benefit of the borrower. They exist for the benefit of lenders to understand how much of a risk the borrow is.
* Credit scores are (mostly) not adjudicated by any human. They come from a complex algorithm, the specifics of which are not released to the public so that people can’t “game” the system.
In order to show that you can manage credit effectively, you need to have credit to manage. If you aren’t managing any credit, the algorithm can’t judge how good you are at doing it. What the algorithm wants to see is a variety of types of credit. They want to see that you can handle short-term credit like a credit card, and a long term loan like a mortgage or car loan. When you pay off your car loan, that long-term data point disappears, and the algorithm considers you to be a higher risk because it can no longer judge how well you manage that sort of credit.
Additionally, someone without any lines of credit is probably looking to take out some lines of credit. I mean, why not? If you aren’t making payments on anything, you can afford to take on new payments. If someone is a reckless spender, they might “celebrate” paying off a loan by taking out a new loan that is too big. The algorithm doesn’t know this, the algorithm just looks at historical data from decades of tracking loans and payment data.
Note, though, that paying off loans will *raise* your credit more often than not. Even if the score goes down immediately after you pay off the loan, that you successfully completed the loan matters more and will pull your score back up over time, higher than it would be without completing that payment.
Lenders don’t care if you can pay off your debt. They care how much money they can make off of you. Having no debt indicates that you are less likely to give them money in interest than someone who has debt and continues to pay it timely
It’s because of two things
1. Your average credit age goes down (especially if it’s an old loan)
2. The total amount of available credit you have goes down
If I have two $30,000 loans, and withdraw $20,000 from each, I have $20,000 of available credit (money I haven’t pulled from the loan)
If I pay one loan off entirely, closing the account, I now only have $10,000 of available credit
Because the people that profit enormously off of you being buried alive in debt don’t want you to get out of debt, because that means they stop making money off of you. So if paying off debt dings your score, people are less likely to pay it off, or will be sure to stay in debt as they pay things off. I paid off all our debt after my father in law passed and his life insurance payout came to us, and even though I have a CC open, my score has now become “indeterminate” and I don’t qualify for any new loans. Not that I need them, we are now living an ultra low income, ultra low expense lifestyle.
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