Someone finally pays off a car loan or even a mortgage and how are they rewarded? By seeing a drop of anywhere from 10 to 50 points in their credit score.
Perhaps you’ve even been in this situation yourself.
So, what caused your credit score to drop when you paid off that loan?
Why Paying Off a Loan Can Actually Hurt Your Credit Score
In order to understand why your credit score might drop when you pay off a loan, it’s important to know how credit scores are calculated. Here’s an overview:
These percentages tell you how important each one of those factors is in determining your overall credit score:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Credit mix: 10%
It’s the “Credit mix” at 10% that you want to pay attention to here. That’s the one that explains why your credit score can take a hit when you pay off a loan.
“The scoring models pretty much universally want to see as many different types of credit to have the greatest sense of who you are with credit,” says money expert Clark Howard.
According to CreditCards.com, that mix could include:
- Installment loans, including auto loans, student loans and furniture purchases
- Mortgage loans
- Bank credit cards
- Retail credit cards
- Gas station credit cards
- Unpaid loans taken on by collection agencies or debt buyers
- Rental data
While 10% may not seem like a lot, it is enough of a factor that your score could drop anywhere from 10 to around 50 points if you pay off a loan, depending on how many other types of credit you have and how much you’re using.
Still, you shouldn’t feel the need to take on new types of debt just to raise your score.
“People who use only revolving credit like credit cards are going to find that over time that not having a mortgage, not having an auto loan will start to pinch your score,” Clark says. “But even if you only have credit cards — which is all I’ve had for a long, long time — I’m still able to maintain a score in the high 820s. You can have an absolutely great credit score and still have narrow forms of credit that your score is based on.”
Clark thinks that it’s unfair that people are “punished” with a drop in their credit score when paying off a loan shows that you’re actually responsible with credit, but he really wants you to brush it off and look at the bigger picture.
“Don’t become credit score-obsessed unless you’re in the process of trying to buy something and you’re on the bubble score-wise,” he says. “If your credit score is in the upper 700s or higher, you’re going to be able to get the most preferential interest rate on anything you want.”