Will paying down the debt have an impact on my credit rating?



Paying off that large balance that you’ve been carrying for months on your credit card or making a final deposit for your years of student loans feels unbeatable. But more than giving you peace of mind, paying off your revolving and installment debts brings you closer to financial freedom.

Revolving credit (credit cards) is a credit extension with an assigned spending limit but no end time for the loan, while installment credit (loans) offers borrowers a fixed amount over a specified period of time. . No matter what type of debt you owe, you usually have to pay interest on overdue balances. The sooner you can pay off those debts, the less money will come out of your pocket.

Having said that, a common misconception is that paying off your debt always and instantly increases your credit score. It is true that getting rid of your revolving debt, like credit card balances, helps your score by lowering your credit utilization rate. However, closing some lines of credit may in fact temporarily thing your credit score. Paying off your installment loans, which also includes things like auto loans and mortgages, can sometimes have the opposite effect.

“It can be frustrating to see your credit score drop when you make a wise financial decision,” says Amy Thomann, head of consumer credit education at TransUnion, one of the three major credit bureaus. But before you get discouraged, find out why this is happening and how much it matters in the long run.

According to Experian, another credit reporting agency, there are several reasons your score may drop when you pay off an installment loan.

  1. You have paid your only installment account: Lenders like to see that you can handle a variety of different types of debt. Since your credit mix represents 10% of your FICO credit score, paying off the installment line of credit alone can cost you a few points.
  2. You paid your account to the lowest balance: Outstanding balances on all of your open credit accounts, or amounts owed, represent 30% of your credit score. If the installment loan you paid off had the lowest balance, reducing the average amount owed and leaving your only remaining active accounts with high balances, your credit score may drop.
  3. Something else happened: Although you may have paid off an installment loan and immediately saw your credit rating go down, it could just be a coincidence and something else caused your credit rating to drop. Remember that there are a number of factors that impact your score, such as applying for a loan or getting a new credit card, or building up a high credit card balance in the meantime.

If you see a drop in your credit score when paying off an installment loan, be aware that it is likely low and temporary.

Why you should still try to pay off your debt

Just because paying off an installment loan could hurt your credit score, don’t leave it open just to maintain a high score.

You wouldn’t want to pay unnecessary interest over time just to save a few points, and your 3-digit score may bounce back. The average credit score recovery time after closing an account (for those with poor credit to fair) is three months, according to Bankrate. Making a series of monthly bill payments on time is the fastest way to improve your score. (Payment history is the most important factor.)

“Remember: your credit score is only one part of your overall financial health,” says Thomann, stressing the importance of reducing interest and overall debt. “Making the effort to actively engage and take control of your credit health increases your chances of achieving your financial goals over time.”

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Editorial note: The opinions, analyzes, criticisms or recommendations expressed in this article are those of the editorial staff of CNBC Select and have not been reviewed, endorsed or endorsed by any third party.


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