Table of Contents

    How Paying Off Your Debt Can Actually Harm Your Credit Score

    Having a lot of unpaid debts can cause your credit score to plummet - but did you know that paying down certain types of debt can drop your score even further? 

    It’s true: zeroing some kinds of debt doesn’t help your credit score right away.

    Read on to learn more about this contradiction in detail.

    So, How Can This Be True? 

    Pay down your debts - it’s one of the first things that any financial advisor will tell you. 

    The bigger your credit balances, the lower your FICO score will drop - and the logical solution would be to reduce them as fast as possible.

    But there are certain types of credit (like installment loans) that are exceptions to this rule. 

    • There are two main types of credit: revolving credit and installment loans.
    • Credit utilization (the amount of your available credit that has been used) can lower your credit score since it makes up 30% of your FICO score. 
    • Paying down your revolving credit (like credit cards is definitely good for your credit score because it reduces the total amount you owe. 

    Now here’s something that surprises many borrowers: installment loans don’t count toward your credit utilization. 

    These loans are issued as a lump sum payment and repaid in regular monthly installments - and the credit bureaus don’t expect them to be repaid any sooner than agreed. 

    For this reason it may not make sense to zero your installment loans for these reasons:

    1. It could lower your FICO score because you’ll be closing an account prematurely and losing points for credit history which is the biggest factor that determines your score.
    2. Your lender may charge you an early settlement penalty which could be more costly than the interest you would’ve paid on your installment loan - especially if you were just a few months away from repaying it in full.

    Instead of repaying your loans in advance you can take other steps to improve your credit.

    Below we discover how. 

    Factors That Affect Your Credit Score

    The two main credit scoring systems (FICO and VantageScore) use similar factors to calculate your score:

    1. Payment history - How long your accounts have been open and how reliably you pay them.
    2. Credit utilization - How much of your available balance you’re currently using.
    3. Recent credit accounts - How many new accounts you’ve applied for lately 
    4. Credit mix - How many types of credit (loans, credit cards, a mortgage etc.) you currently have in your name. 

    Let’s go through the first three factors in more detail.

    Payment History And Length 

    The age of your credit accounts and how well you manage them make up a combined 45% of your FICO score. 

    • Your score will rise the longer you keep an account open and the fewer late payments you make.
    • Closing an account prematurely can lower your credit score. This is true of loans and credit cards.
    • It’s beneficial to pay down your credit card debt - but keep your account open even if you decide to cut up your card. 

    Credit Utilization 

    This factor measures how much of your available credit you’ve used.

    It’s usually expressed as a percentage - and you’ll want to keep yours under 30%.

    • If you have a $10,000 credit limit and have used $3,000 already you’re right on 30%.
    • By paying down your card until you owe $1,000 or less you will see a rise in your credit score.
    • It’s important to note that installment loans don’t count toward your credit utilization. All you need to do is pay your monthly installment on time and your score will remain steady. Your credit score may rise once your loan is repaid in full.

    New Accounts

    The number of new accounts you’ve applied for lately (over the past few months) counts 10% toward your credit score. 

    • Opening multiple new accounts at once is a red flag for borrowers because it suggests that you’re in financial trouble and are scrambling to borrow funds.
    • To avoid being penalized by the credit bureaus you’ll want to apply for new credit gradually over several months. 
    • Shopping around for a loan or mortgage shouldn’t cause your credit score to suffer - especially if you apply for each one within a month of the others. 

    Conclusion 

    While paying down your revolving credit is good for your FICO score the same is not true of installment loans. 

    These loans don’t count toward your total credit utilization and paying them off ahead of schedule may actually cause your credit score to suffer. 

    A far better strategy would be to pay down your credit cards, keep your accounts open and in good standing, and not apply for too many new types of credit at once.