Paying credit obligations on time has the potential to help you establish solid credit reports and scores. This concept is easy enough to understand. But what happens when you finally pay off a loan in full? Will paying off a loan hurt my credit scores?
Many people expect their credit scores to increase when they pay off an installment loan like a mortgage, auto loan, personal loan, or student loan. And there are indeed times when paying off debt could lead to higher credit scores. For other people, however, a newly zeroed-out loan balance might not have any credit score impact, at all. And sometimes paying off a loan might lead to a temporary credit score decline.
It’s entirely counterintuitive until you dig into the analytics of credit scoring systems and why they “count” things in the scoring process. Credit scoring models consider a variety of different factors when calculating your credit scores. The best example of this is the fact that your payment history is worth only 1/3rd of the points in your credit scores. That means a full 2/3rds of the points in your scores have nothing to do with making or missing payments.
One of those many factors that can influence your credit scores is the presence of active accounts appearing on your credit reports. In general, proving to scoring systems that you can properly manage debt causes them to reward you. Conversely, having few or no active accounts gives scoring models less to consider.
It’s also worth pointing out that this article is about installment debt, not revolving credit card debt. Paying off credit card debt is always good, for a variety of reasons, some of which have nothing to do with credit reporting issues. You will usually have a positive credit score impact when paying off a credit card account but not when you pay off an installment loan. When you pay a credit card account down to zero, you reduce the number of accounts with balances on your credit reports. And, you lower your revolving utilization ratio—a factor that has a considerable impact on your credit score.
Although it may sound odd, paying off a loan could possibly have a negative impact on your credit score—at least on a temporary basis. The reason, you’ve just paid off one of the few (or the only) installment account on your credit reports. One of the factors in scoring systems is a record of recent activity on installment accounts.
When you pay off an installment account it goes into what’s called a “finalized status.” When an account goes into a finalized status it is no longer updated by the lender. When an account is no longer being updated by the lender, it appears as being inactive on your credit reports. Of course, nothing here is either incorrect. That’s how the system works. When loans are paid off, they’re no longer loans and no longer active.
Now, I want to be sure to eliminate any potential misrepresentation of what you just read. Paying off loans is not considered to be “negative”, like how a collection or a late payment is considered negative. Inquiries aren’t negative and they can lower scores. Credit card debt isn’t negative and it can lower credit scores. Credit entries other than negative entries can lower scores. That’s the reality of credit scores.
Also, we’re not talking about the difference between FICO 790 and FICO 580 here. We’re talking modest, often unrecognizable differences in your scores. In fact, if you don’t track your scores closely you may not even notice a difference or attribute the difference to the fact that you paid off a debt.
Paying off debt is always a great thing. No debt equals no interest. No debt equals more money in your pocket every month. No debt also means you likely now own your car, your home, or you’ve paid off student loans. Even if you experience a temporary credit score setback, who cares? It’s very likely that you still have lenders falling over themselves trying to offer you a way to get back into debt. Enjoy your debt free life.