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Finally, you really feel good about repaying a debt that you have been paying for months or even years.
But if you've been there before, you know that erasing a loan or a large credit card balance can temporarily reduce your credit score. It sounds like a cruel trick – after all, is not the debt the mortal enemy of excellent credit? This is true, but there are some more important factors in the composition.
Although we do not know exactly how credit ratings are calculated, the major rating agencies generally place special importance on the same five factors. According to FICO, here is the breakdown:
- 35% of payment history
- Current debt balance of 30%
- 15% of the length of the credit history
- 10% new credit
- 10% credit composition
Closing an active account can have a negative impact on your credit.
In addition to the amount of credit you use and your ability to make payments on time, the average age of your active accounts has an impact on your credit in general. The longer an account is open, the better your credit score. If you make regular payments on long-term accounts on a regular basis, you are probably in good shape in terms of credit. Accounts include not only credit cards, but also the "installment loans" that you currently have, including student loans, home, auto and individuals.
The difference between credit cards and loans lies in the fact that when you pay a balance of the old, your card remains active. However, when you make the final payment of a loan, the account will be closed. This is where the problem lies: if the oldest account of your credit report is a student loan contracted 10 years ago, this account will no longer be taken into account in the average age of your account. active accounts once that is paid.
A temporary blow to your credit score is not a reason to avoid paying off your debts
Credit rating agencies also look at something called the composition of your credit, although this is not usually a determining factor in your credit score. If you have five credit cards, a mortgage and a car loan, you have a good mix of different types of credit. The repayment of any of these loans will reduce your credit variety.
When it comes to credit cards, your credit utilization rate has a very big impact on your credit in general. The use of credit is the percentage of your total credit limit that you are currently using. Experts recommend a credit usage of between 10% and 30%. When you have credit card debt outstanding, this ratio will likely be higher. But when you pay your balances, it goes down.
Even if your credit score drops slightly after paying the balance of a credit card, it will not last long. As long as you do not close the entire account and continue to make payments on time for any new balance, your score must be neutralized and then increased in no time.
That said, anticipating a temporary hit on your credit score is not a reason not to pay your debts. The balances of the current debt – including the debt you owe and the debt you pay every month – make up about 30% of your overall credit score. As a result, their repayment has a much greater benefit in the long run. Moreover, the more you drag your debt, the more interest you pay.
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