Here’s why your credit score may drop after paying off your personal loan - CNBC

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Paying off a loan can feel like a weight off your shoulders, especially if carrying debt makes you uncomfortable. But there are some other benefits to focusing on paying down debt, like improving your debt-to-income ratio and building your credit score.

Typically, paying off revolving debts like credit card balances can help you improve your credit score, assuming no other payments have been made late and you don't sign up for several new lines of credit all at once.

But when it comes to installment debts like personal loans, you may not notice any changes to your credit score after paying off the balance — in fact, in some cases you may even see your score drop slightly as a result. This can feel both confusing and discouraging, but there are a few reasons why you may not see an increase in your credit score after paying down a personal loan.

Just keep in mind that such a drop in your credit score is temporary and you should never avoid paying off debt because of it; your credit score can always be recouped over time by continuing positive credit management habits like maintaining a low credit utilization ratio and never missing a payment.

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The average age of your accounts has now decreased

The length of your credit history makes up 15% of your FICO score. It is calculated by looking at the age of each of your open credit accounts and finding the average among them. Typically, the longer your credit history, the higher your credit score tends to be.

If your personal loan is one of your oldest standing accounts, once you pay it off it becomes closed and will no longer be accounted for when determining your average account age. Because of this, your length of credit history may appear to drop. However, over time your average account age and your length of credit history can increase since you will have been a credit consumer with other forms of open credit for even longer.

You now have a less diverse credit mix

Another important factor in determining your credit score is credit mix. Credit mix accounts for just 10% of your FICO score, but it's still a sizable part of determining your creditworthiness. Credit bureaus want to ensure that you have a track record for effectively managing different types of credit, including credit cards, car loans, a mortgage and any other forms of credit.

A credit card is a widely-used form of credit, but also having an open personal loan account may be contributing to a more diverse credit mix since credit cards are a form of revolving credit and personal loans are a form of installment credit.

With revolving credit, you receive a limit and can repeatedly borrow as much money as needed up to that limit as long as you're repaying what you borrow. But with installment credit, you're given a fixed amount of time to pay off the total amount you borrowed, and it is usually paid off in fixed monthly increments. Different lenders have different repayment periods (aka, loan terms) — personal loans from Upstart, for example, have loan terms starting at 36 months, while OneMain Financial Personal Loans have terms as short as 24 months.

So if your personal loan was the only non-credit card account you had and you paid it off and closed it, you'll end up with a much less diverse mix of credit, which could be a reason for a seeing a drop in your credit score.

Upstart Personal Loans

• Annual Percentage Rate (APR)

  6.95% to 35.99%

• Loan purpose

  Debt consolidation, credit card refinancing, wedding, moving or medical

• Loan amounts

  $1,000 to $50,000

• Terms

  36 and 60 months

• Credit needed

  FICO or Vantage score of 600 (but will accept applicants whose credit history is so insufficient they don't have a credit score)

• Origination fee

  0% to 8% of the target amount

• Early payoff penalty

• Late fee

  The greater of 5% of monthly past due amount or $15

Terms apply.

OneMain Financial Personal Loans

• Annual Percentage Rate (APR)

  18.00% to 35.99%

• Loan purpose

  Debt consolidation, major expenses, emergency costs

• Loan amounts

  $1,500 to $20,000

• Terms

  24, 36, 48, 60 Months

• Credit needed

• Origination fee

  Flat fee starting at $25 to $onem00 or percentage ranging from 1% to 10% (depends on your state)

• Early payoff penalty

• Late fee

  Up to $30 per late payment or up to 15% (depends on your state)

Terms apply.

You recently applied for another line of credit

Of course, you may also ask yourself if paying off your personal loan and seeing a drop in your credit score may have coincided with you applying for a new credit card, taking on a car loan or even increasing your spending on an existing credit card. These are all actions that can temporarily lower your credit score since applying for a new line of credit opens up a hard inquiry on your credit report, and increasing your credit card spending means increasing your credit utilization ratio.

Credit utilization is a measure of how much credit you're using in relation to how much credit is available to you. Generally, a high utilization ratio indicates that you're using too much credit, so experts typically recommend keeping this ratio under 30% to maintain a healthy standing.

Bottom line

Paying off a personal loan can have an affect on your credit score, but ultimately the size of the impact depends on your credit profile, including how long you've had credit accounts open for, how diverse your credit mix is and what other forms of credit you've been applying for.

While it can be discouraging to see a slight dip in your credit score after paying off a personal loan, remember that the drop will only be temporary — over time, continuing to make on-time payments on your other accounts and being mindful of your credit utilization can help you increase your credit score.

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Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.

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Here’s why your credit score may drop after paying off your personal loan - CNBC
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