Why does paying off your debt lower your credit score?
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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.
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