Why does paying off your debt lower your credit score?
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The credit bureaus look at what is called “Credit Utilization”. They want to see the amount that you owe below roughly 30% of your available credit. Having no amount owing compared to your available credit does not provide them with any actual tracking of how responsible you are in paying your debts, if you actually owe nothing. Seems counter-intuitive but this is my basic understanding that owing *something* and keeping on top of your actual utilization and debt is better than owing nothing at all.
I may be completely out to lunch on this, and I too would appreciate further clarification if anything I’ve said is inaccurate.
The open account (like a loan) is reported to the credit scoring companies as an *open* account (adds to your total number of accounts) and hopefully has a history of on-time payments. Once you pay it off, the account closes, so it no longer gets factored in to these two important scoring criteria. If anything it shows as an account that is closed and not much else.
edit: Writing this assuming we’re talking about something like a car loan or mortgage, not regular credit card debt. Paying off credit card debt in full is wonderful for your credit score, especially if you do it on time, as long as you don’t close the account afterwards.
Assessing risk is only part of the purpose of credit scores. The credit agencies get their money from the finance industry, and the finance industry makes more money if you’re constantly in debt.
Why wouldn’t the credit agencies reward behavior that makes them and their customers more money?
The simple answer is a credit score doesn’t represent how fiscally responsible you are but how good you are at making lenders money. People that never miss payments but don’t pre-pay create steady streams of interest revenue for lenders.
The credit score (Fair Isaac Corporation, or FICO) was designed as an actuarial table for lenders. If a lender gives each of 100 people with a credit score between X and Y a $10,000 loan, they have a very good idea how many will pay back the loan on time or early, how many will have some trouble but will eventually pay it back, and how many will default. They won’t know which of the 100 will fall into each category, but they don’t need to. Once they know the default and slow payback rates, they can estimate pretty accurately what rates to charge in order to ensure a profit.
After studying loans/people/repayments, it has developed into 5 variables (FICO; other scores use other variables).
Payment history, amount owed, length of credit history, recent activity, and types of credit are the information pulled from the credit bureaus to derive your score. If you don’t borrow money, you won’t have a credit score. If you borrow money (say for your first time use of your first credit card), you will have a low credit score. Over time, as you borrow and repay, your score will go up.
The great news is that a credit score is not an essential part of a successful financial plan. BUT if you are going to have a credit score, a good one is way better than a bad one…
SO if you have 3 loans today, and you pay one off, next week you “only” have two loans. Ii is possible, based on the importance assigned to each variable, for your score to drop, even though you acted as a “good borrower” and repaid the loan.
A credit score is not particularly useful. One of the things it’s used for is to try and estimate your income in situations where a lender doesn’t/can’t verify your income.
If you reliably pay $1000 worth of debt each month without incurring any additional debt, then the credit bureau knows you have at least $1000 of disposable income.
Once you completely pay off a debt, you may only be paying $500 each month, so the bureau no longer knows how much disposable income you have. Maybe it’s still what it was before, maybe it dropped, maybe it went up, who knows? This uncertainty causes your score to drop.
It’s not really anything worth worrying about though because for anything important like a mortgage, the lender will actually verify your income. That means they will know that your disposable income actually went up once your monthly debt payments went down by $500/month, which means your ‘mortgage score’ will go up.
It only “lowers” your score if the debt you pay off is not revolving. if you pay off a loan, that account is closed, which can temporarily lower your score. Usually just a little, though, since it is not tied to a negative “reason”. But, your “available credit” does go down, which can make your score go down.
It’s a really weird, hard to ELI5 system.
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