With debt becoming an increasing issue in the United States in recent decades, many Americans are making a concerted effort to reduce their overall debt load. More than ever, consumers are working hard to minimize the credit card debt they have to spend less money on interest and save for the future. As these borrowers make changes to their finances, their credit report reflects these changes which can lead to fluctuations in their credit scores.
Some individuals, and you might be one of them, experience a temporary drop in their credit score as they pay off their debts. This might be a confusing outcome for some borrowers as it is often assumed that becoming debt-free will lead to an automatic increase in their credit score. While minimizing your debt will be excellent for your credit in the long run, the effect might not be immediate, and you may see a drop before you see the end product.
The reasons for this revolve around how credit reports function in relation to credit scoring models. Gaining a more thorough knowledge of how credit works will help you better understand why there can be fluctuations in your credit score throughout the journey to financial freedom. We will break down exactly what information is included in your credit report, how that translates into a three-digit credit score, and what might be the cause of temporary drops from credit utilization to the age of credit accounts.
How Your Credit Report Works
Credit reports are central to people’s overall financial well-being. Credit reports are used in the approval of all new forms of credit but not only that. In addition to lenders, credit reports are often consulted by landlords, insurance companies, and even employers. Credit reports are compiled to be a good representation of your overall financial responsibility and credit worthiness.
Three Credit Bureaus
There are three major credit bureaus in the United States that compile an individual credit report for each consumer–Experian, Equifax, and TransUnion. Every consumer has the legal right to request a free copy of their credit report from each credit bureau once every year.
Your credit report includes information about your credit accounts, credit inquiries, public records, and collection accounts. It will also include personally-identifying details to connect you to your report for accessibility.
Calculation of Credit Scores
There are several different credit scoring models available but, by far, the most common ones are the FICO score and VantageScore. Both scoring models utilize five categories to calculate your individual three-digit score. Each category accounts for a different percentage of your score’s calculation. Here is the general formula most credit scores follow:
Payment History — 35%
The payment history of all the credit accounts on your credit report make up 35% of your credit score calculation, making it the most considerable portion of your score. All on-time payments, late payments, and missed payments for every credit account type, from credit cards to monthly installment loans, are used in calculating your score.
It is for this reason that so many financial experts so strongly emphasize the importance of making your payments on time to maintain a good credit score. Every late payment you make can stay on your credit report for up to seven years.
Amounts Owed — 30%
30% of your credit score is your overall credit usage, i.e., the total amounts owed in both revolving credit and loans. Your credit utilization ratio plays an important role in this category and can make a significant difference in your score as you are repaying debt.
Your credit utilization rate is the amount of money you owe compared to the available credit you have in your total credit limit — a lower credit utilization rate signals responsible credit habits and results in higher credit scores. Most financial experts recommend a credit utilization of 30% or below.
Length of Credit History — 15%
The length of your credit history accounts for 15% of your credit score and takes into consideration the age of your oldest credit account, the age of your newest account, and the overall average account age. A credit history that has been established for a longer period of time will give a consumer a better credit score.
Closing credit card accounts should not affect this portion of your score too much unless it was an account you closed years ago. Closed credit card accounts remain on your credit report for up to 10 years.
Credit Mix — 10%
The variety of credit that you have is 10% of your credit score. The idea behind this category in the calculation is to encourage a more diverse credit mix so consumers don’t have only one type of credit account. Account types can include personal loans, credit cards, auto loans, mortgage loans, etc.
New Credit — 10%
Whenever you fill out an application for a new loan or credit card, you are authorizing that credit card issuer or lender to pull a copy of your credit report. Each time this happens, a new hard inquiry will appear on your credit report. Too many hard inquiries on your credit report within a short period of time can make you appear desperate for credit which can cause credit card issuers to see you as a credit risk. Hard inquiries, along with too many new accounts, can bring your credit score down.
Soft inquiries, which include checking your own credit and pre-approval offers, are noted in your credit report as well but do not affect the calculation of your score.
Reasons Why You Might See Your Credit Score Drop
Even if you are doing everything right to improve your financial situation, you might still see a drop in your credit score. This might be frustrating, but if it happened because of a decrease in your credit card balance, you are likely to see it even out soon. There are several reasons why you might see changes in your credit score while paying off your debts. While most of these reasons are minor and short-lived, knowing what they are will help you keep an eye out for them and possibly allow you to avoid too much damage or rebuild your credit more quickly.
Changes in Credit Utilization
Any major shift in your credit utilization rate will result in some significant changes in your credit score. It’s ideal to have a higher credit limit and lower used credit so if your total limit suddenly decreases after the closing of a credit card, your credit utilization will likely increase. And a higher credit utilization will bring down your credit score. While the closed credit card account will remain in your credit history, its credit limit will not be included in your total available credit.
For example, if you have five credit cards, each with a credit limit of $2,000. Let’s say you have a balance of $1,000 on four of the cards and a $0 balance on the fifth. With all five accounts open, your credit utilization rate would be $4,000 out of $10,000 which is a 40% ratio. If you close the account with a zero balance, your utilization ratio will automatically jump up to $4,000 over $8,000, which is 50%. A percentage increase like this would cause your credit score to drop.
Lack of Diversity in Your Credit Mix
If you are paying off a variety of debts, you could experience a temporary drop in your credit score from a change in your credit mix. Paying off a car loan is an incredible accomplishment but it will decrease the variety of credit accounts you have active on your report. Your credit score could go down if you only have one type of debt left on your report.
Average Age of Credit Accounts
If you closed some accounts a while back, you might see a change in your credit score especially if it was one of your oldest accounts. Your average account age as well as the age of your oldest account, is crucial to calculating how well-established your credit history is. A large shift in the age of your credit history would lead to a drop in your credit score that could require some effort of credit rebuilding to rectify.
Tips for Avoiding a Credit Score Drop When Paying Off Debt
Thankfully, there are some actions you can take to minimize damage to your credit score while paying off your debt. And there are a myriad of ways to rebuild your credit after an unexpected blow to your score. Here are some suggestions for how to keep your credit in good shape before or after a drop in your score:
Keep Credit Accounts Open
Once you have paid off a credit card’s balance, avoid closing the account immediately. While it might feel good to close a credit card for the finality of it, keeping the account open could protect your credit utilization rate. Consider leaving the account open and not using the card. If you are afraid you will be too tempted to use it, you can hide the credit card in your sock drawer or freeze it in a block of ice in your freezer.
If the credit card issuer requires that you carry a balance, you could simply use the card for an auto-payment on an inexpensive bill such as your Netflix subscription. You can pay off the charge each month, allowing you to keep the card open without using it regularly.
Use Credit Sparingly and Responsibly
As you move forward after minimizing your debt, it is important to still practice responsible credit usage. Use any remaining credit cards you have open sparingly so you don’t end up in a situation where you have an overwhelming amount of debt. It might be necessary to make several lifestyle changes so you can decrease your dependency on credit cards. To use credit responsibly, it is crucial to not spend money that you don’t actually have. Ideally, you want to have the ability to pay off the balance at any moment.
Stop Applying For New Credit
To give time for your credit to recover, take a break from applying for any new credit products. Too many new hard inquiries on your credit report can exacerbate any harm caused by minor changes in your credit account balances. Put your focus towards paying down your current cards rather than applying for or opening any new ones.
Check Your Credit Report Often
Checking your credit report regularly can help you catch any mistakes on your report before they have a chance to harm your credit score. If you ever see any errors or inaccuracies on your credit report, you can dispute them right away to the credit bureaus so they can be rectified. But if you never check your credit reports, you’d have no idea if a drop in your credit score is simply the result of an error that can be easily fixed.
Consider Paying Off Full Balances
If you are able, we recommend paying off the total balance on your credit cards every month. Not only will this allow you to save a significant amount of money on interest but it will also keep your credit utilization as low as possible. A credit utilization of 0% will ensure a great credit score and a life that is not bogged down by the stress of credit card debt.
Have Patience While Rebuilding Your Credit
Unfortunately, building credit after a drop in your score is not something that happens overnight. It might require patience on your part as you continue to do the things you know are good for your credit. After some time, you are sure to see the results of all the time and effort you put into improving your credit history. Just stick with it and eventually you will see the outcome of your consistency.
References:
Why Credit Scores Could Drop After Paying Off Credit Cards | Experian
Why Did My Credit Score Drop? | Capital One