Why does credit score drop after paying off a loan?
In: Other
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.
Latest Answers