I thought paying off my car would help my credit score. I was wrong.
Years back, when I learned I was having twins, I was thrown for a huge financial loop. Having multiples meant having to buy a host of baby gear since we only had one set to hand down from our older child. It also meant we wouldn't be able to fit our children into our old car, since my son was only a toddler when the twins were born and we needed a vehicle that could accommodate three car seats.
As such, we did what all hip parents do -- we bought a minivan. But since we couldn't pay for one outright (minivans, though obviously uncool, are surprisingly expensive), we decided to finance it with a multi-year auto loan.
For several years, our car payments ate up a huge chunk of our budget, so I was thrilled when we finally made our last payment. But when I checked my credit score after paying off my auto loan, I saw something surprising -- my score had gone down.
Why paying off a loan can hurt your credit score
You'd think that from a credit score perspective, you'd be rewarded for paying off debt. After all, one less loan means one less financial obligation. Also, all loans are designed as such that you're supposed to eventually be free of them. Nobody signs a lifetime mortgage, for example. Rather, home buyers will commonly sign a 15-, 20-, or 30-year loan and be done paying it in that time frame.
That's exactly what happened to me with my auto loan. After years of payments, I no longer owed money on my car.
So why did my credit score drop? Well, there are a couple possible reasons.
Average age of accounts
First, the average age of your various accounts goes into calculating your score. That's why it's always wise to hang onto credit cards you've had for a long time, even if you rarely use them. In my case, that auto loan was part of my credit history for a number of years, so when it disappeared, it may have reduced the average age of my open accounts, thereby bringing my score down a notch.
Another thing is that other than my mortgage, once my car loan was paid off, my only remaining accounts on record were credit cards -- and I happen to have a number of them. A separate factor that goes into calculating a credit score is your credit mix. And you'll typically be rewarded for having a nice balance of credit cards plus installment loans -- meaning, loans you pay off in equal amounts over time. By getting rid of my auto loan, I may have tilted my credit mix into less favorable territory, which could also explain why my score dropped.
Now to be clear, my credit score only went down about 15 points when my auto loan disappeared, so it wasn't a catastrophic drop. But if you're planning to pay off a loan you've had for a long time, you may want to gear up for a temporary hit to your credit score -- despite the fact that you did the responsible thing by paying off the debt like you were supposed to.
Alert: highest cash back card we've seen now has 0% intro APR until 2025
If you're using the wrong credit or debit card, it could be costing you serious money. Our experts love this top pick, which features a 0% intro APR for 15 months, an insane cash back rate of up to 5%, and all somehow for no annual fee.
In fact, this card is so good that our experts even use it personally. Click here to read our full review for free and apply in just 2 minutes.
Our Research Expert
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2023 The Ascent. All rights reserved.