Surprise: Paying Off Debt Can Actually Hurt Your Credit

It may seem counterintuitive, but in some cases, paying off a loan can hurt your credit, albeit temporarily.

There are several factors that go into calculating your credit score, each of which is weighted differently:

• Payment history, which speaks to your tendency to pay bills on time (35% of your score).
• Credit utilization, which is the amount of available revolving credit you're using at once (30% of your score).
• Length of credit history, which speaks to how long you've been a borrower in good standing (15% of your score).
• New accounts, which refers to the number of new credit accounts you've opened or applied for in a short timeframe (10% of your score).
• Credit mix, which speaks to the different types of credit accounts you hold (10% of your score).
  
  

You'll often hear that if you want your credit score to improve, a good way to make that happen is to pay off a large chunk of credit card debt. The reason? The less revolving debt you carry, the lower your utilization ratio will be -- and the smaller that percentage, the more your credit score will improve. But in some cases, paying off a personal loan or other installment loan can actually have the opposite effect -- it could bring your credit score down. 

Why your credit score might drop when you pay off debt

Your credit utilization ratio is calculated based on your outstanding revolving debt. Revolving debt isn't preset; you borrow as you need to, and then pay off what you owe over time, sometimes making just a minimum payment (a common practice among credit card holders).

By contrast, installment loans don't count toward your credit utilization. Installment loans refer to loans where you owe a specific amount over a preset period of time. An auto loan is a good example of an installment loan; you borrow a certain amount of money to finance a vehicle and are given a timetable for paying it back. You can't just opt to make a minimum payment -- in this case, your minimum payment is the monthly payment you owe under the terms of your loan. 

You'd think that paying off an installment loan would help your credit, but actually, in some cases, it can hurt your score temporarily. The reason? Length of credit history is a key factor in determining your credit score, and so the longer you hold accounts in good standing, the more it helps your score. Closing one of those accounts, by contrast, leaves you with fewer accounts in good standing, and so your score could take a small hit when you pay off a long-term loan.

So does that mean paying off a loan is a bad thing? Not at all. In fact, when you close an account in good standing, the hit your credit score takes is generally pretty short-lived, lasting just a few months. And remember, sticking to your loan repayment schedule is a great way to help your payment history, which is the single most important factor in calculating your credit score. 

How to keep your credit score in good shape

If you're worried that paying off a long-standing loan will hurt your credit score, there are a few other things you can do to compensate. First, you can also try paying off a chunk of credit card debt to improve your utilization. If that's not possible, call your credit card companies to see if they'll raise your credit limits. Doing so could also bring down your utilization ratio. 

Additionally, stay current on all of your bills to keep your payment history strong, and avoid closing credit cards you've held for a long time but don't use. Having those accounts in your name will help your credit history, so as long as you're not being charged a whopping annual fee to retain them, it makes sense to keep them open. 

Finally, avoid applying for too many new loans or credit cards at once. Rather, space those applications out by several months. 

While paying off debt can, in some cases, hurt your credit temporarily, it's still a wise thing to do. And remember, the hit on your score for closing an account won't be nearly as bad as a hit associated with a late payment, so your best bet is to always stick to the schedules your lenders set.