Paying off that large balance you carried for months on your credit card or making one last deposit toward your years of student loans is an unbeatable feeling. But more than just bringing you peace of mind, paying off your revolving and installment debts brings you closer to financial freedom.
Revolving credit (credit cards) is an extension of credit with an assigned spending limit but no end time to the loan, while installment credit (loans) offers borrowers a fixed amount of money over a specified period of time. No matter what kind of debt you owe, you typically have to pay interest on the outstanding balances. The sooner you can pay these debts off, the less money coming out of your pocket.
That said, a common misconception is that paying off your debt always and instantly increases your credit score. It's true that getting rid of your revolving debt, like credit card balances, helps your score by bringing down your credit utilization rate. Yet, closing certain lines of credit can actually temporarily ding your credit score. Paying off your installment loans, which also includes things like car loans and mortgages, can sometimes have the opposite effect.
"It can be frustrating to see a drop in your credit score when you make a smart financial decision," says Amy Thomann, head of consumer credit education at TransUnion, one of the three main credit bureaus. But before you get discouraged, know why it happens and how much it matters in the long run.
According to Experian, another credit bureau, there are a few reasons why your score may drop when you pay off an installment loan.
- You paid off your only installment account: Lenders like to see that you can manage a variety of different types of debts. Considering your mix of credit makes up 10% of your FICO credit score, paying off the only line of installment credit can cost you some points.
- You paid off your lowest balance account: The outstanding balances across all of your open credit accounts, or your amounts owed, makes up 30% of your credit score. If the installment loan that you paid off had the lowest balance, thus bringing down the average amount owed and leaving your only remaining active accounts with high balances, your credit score may drop.
- Something else happened: Though you paid off an installment loan and immediately saw your credit score decrease, it could just be a mere coincidence and something else caused your credit score to drop. Remember that a bunch of factors impact your score, such as applying for a loan or new credit card or racking up a high credit card balance in the meantime.
If you do experience a dip in your credit score when paying off an installment loan, know that it is likely small and only temporary.
Why you should still aim to pay off your debts anyway
Just because paying off an installment loan could ding your credit score, don't keep it open just for the sake of maintaining a high score.
You wouldn't want to pay unnecessary interest over time just to save a few points, and your 3-digit score can bounce back. The average credit score recovery time after closing an account (for those with poor to fair credit) is three months, according to Bankrate. Making a series of monthly on-time bill payments is the fastest route to improving your score. (Payment history is the most important factor.)
"Remember: your credit score is just one piece of your overall financial health," Thomann says, emphasizing the importance of reducing interest and overall debt. "That you're making the effort to actively engage and take control of your credit health makes it more likely you'll reach your financial goals over time."
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Here's when paying off debt can actually hurt your credit score - CNBC
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