Why does credit score drop after paying off a loan?
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Because the banks want to know you can pay them interest over time.
I recently bought a new truck and the dealership played hardball on the loan and gave me a 7.8% loan with a 838 credit score according to their credit pull.
I paid off the entire balance of the loan a month later with cash savings and my credit score went down twice, once from their inquiry (first credit inquiry in over 5 years) and again when I paid off the loan. Credit scores are stupid.
Because the entire system is a made up, irrational farce?
Total credit available is a factor. Case in point I was holding a withdrawn CC that was in runoff at tens of £ for ages, paying the minimum monthly, specifically to maintain my credit score. When it was finally fully paid off, the account closed, my total credit available (from the point of view of the credit ref agencies who are apparently unable to distinguish between normal CCs and those in run-off) dropped by £10k and my credit score fell. That seems counterintuitive when you just paid off a debt, but it is how the system works.
I remember hearing once, your credit score is an “I love debt” score. You want to have debt that your are paying off. If you completely pay off a debt, you obviously don’t love debt enough.
Probably said “tongue in cheek”
Some of the factors the scoring model looks at are number and variety of accounts, average age of account. So if a 5 year long car loan drops off your account because you’ve paid it off, it may reduce your average account age, as well as dropping the number and types of loans.
Typically, the score will regain some of those points initially lost when account gets closed/removed from your report over the next few months.
The short answer is that lenders don’t want you to pay off debt. They want you to pay interest and/or pay transaction fees.
I feel like a lot of people think credit scores are like a grade of how good you are with your money. Like, if you had no debt, you would have a perfect credit score. While that makes sense from a borrower’s perspective, it’s not the best from a lender’s perspective. And the score is there for lenders, not borrowers. Lenders ideally want you to go through a lot of credit (generating them income), pay it off in a reasonable time (low risk), with no insurance claims, for as long as possible. Paying off a loan conflicts with two of those ideals.
It’s a score to measure how profitable of a consumer you are. They don’t want you to pay off a loan. They want your interest payments. If you are paying off your debts or not perpetually indebted, you are not paying interest.
Because it’s designed to KEEP you in debt. It rewards you for keeping a moderate amount of debt. You should get a mandatory increase on your credit score when you pay off a debt, and it’s an absolute farce that this isn’t the case.
People in the comments making a crucial mistake
Your credit score is not how likely you are to pay off a loan
Your credit score is how appealing you are to loan companies as a customer
The best person to give a loan to is someone who takes out too much credit from multiple sources and can make the minimum payments forever
That’s why the most valuable variables in your credit score are how long you’ve had lines of credit open continuously the amount of lines of credit you have open and never missing a payment.
If you take out one small loan and pay it off right away, why would I lend you any money? I’m better off just investing that money in a money market fund or risking it in the stock market.
Loaning money to you is only better if you stay in debt for a long period of time
Your credit score is a reflection of how good of an investment giving you money is. Not how responsible you are with that money.
Your credit score is based on a few things, but let’s talk about the three main ones. First, there’s capacity, which is how much you’re borrowing compared to how much you can borrow. Credit cards are a big part of this. Then, there’s payment history, which is all about how well you’ve paid back loans in the past and how you’re doing now. Lastly, there’s credit mix, which looks at the different types of loans you have, like credit cards, car loans, and home loans. Having a mix can be better. Car loans and mortgages impact your credit more than credit cards. Personal loans also help your score more than credit cards, but not as much as car or home loans.
Scenario One – Let’s say you pay off your car loan, but you still have credit card debt and no home loan. Congrats on paying off your car! But now, you have one less positive payment showing up each month. The car loan helped your score a lot because it was a structured loan with collateral (the car). Losing that can make your score drop a bit. This is similar to what happens if you pay off a mortgage too.
Scenario Two – Now, let’s say you’re paying extra each month on your credit cards and lowering the balance. As you reduce your balance, you’re freeing up your credit limit, which is good. If you pay off your credit card, that’s great! You’ll have positive recent payment history and more available credit, which helps your score. Even with a zero balance, credit cards are still good for your credit report. It’s like “no news is good news.” If you pay off a credit card, leave it open unless it has a yearly fee you don’t want to pay.
There is no secret backdoor income calculations done for your credit score as a top answer said, that isn’t true.
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