Lowering your debt to improve your credit score means that you are considered less of a risk to a lender. And with a higher credit score, you will qualify for better financing terms. However, in some cases, paying off a car loan or other type of financing can have the opposite effect and actually lower your credit score.
Here’s a look at why your score could suffer if you pay off a loan. We also look at how you can avoid a drop in your credit score when your financial situation changes.
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Why Did My Credit Score Fall After Paying Off My Car?
A credit score drop could be a direct result of paying off a car loan — or a completely unrelated reason. For example, if you apply for a loan or new credit card, the lender may do a “hard pull” to check your credit score. Too many credit checks within a short period could cause a temporary drop in your credit score, even if you don’t sign for the loan.
If you pay off a car loan, the loan will remain on your credit report for up to 10 years. As long as you always make your payments on time, the loan will continue to have a positive effect on your credit history. Newer accounts, however, have more of an impact on your credit score. So, if you close an old account that you dutifully paid off, your current credit standing could worsen because your regular payments to that old account are no longer taken into consideration.
In addition, when you pay off a car loan, your credit mix changes because you now have one less account in your name. This change can lead to a drop in your credit score.
Let’s take a closer look at factors that affect a credit score and how paying off a car loan can impact them.
Credit Score Contributing Factors
Auto loan lenders typically look at your FICO™ Score or your VantageScore. We’ll focus on the FICO Score because it’s probably the most popular. Four main factors make up your FICO credit score with varying weights. Here’s a look at each of them.
Payment History
Your payment history makes up 35% of your FICO Score, and it is a measure of how likely you are to pay back your debts. The score looks at whether you pay your credit card bills, your mortgage, and any installment loans on time. A few late payments on credit cards or a mortgage won’t ruin your score, but any bankruptcies or collections may. If you need help spotting upcoming bills and managing payments, tools like a money tracker app can help.
Credit Utilization
Your credit utilization rate makes up 30% of your FICO Score. This is the amount of revolving credit versus the total amount of credit available to you. The lower your utilization percentage, the better your credit score because it shows you are not maxing out your credit — so you’re better able to pay back a lender.
Your total available revolving credit includes the amount you can spend on credit cards and lines of credit like home equity lines of credit (HELOCs). Your credit utilization rate is based on the numbers on your credit report, and this data may lag behind your current limits and balances by a month or more.
A car loan has no impact on your credit utilization rate. However, it can affect your total debt and your debt-to-income ratio.
Length of Your Credit History
The length of your credit history accounts for 15% of your FICO Score. A longer credit history will have a positive effect on your FICO Score. Your credit history takes into account how long your credit accounts have been open, including the age of your oldest account, the age of your newest account, and the average age of all your accounts. So when you close an older credit card account, you may see a drop in your score — regardless of whether you’ve paid off your car loan.
Credit Mix
Your credit mix is the type of credit you have — for example, credit cards, mortgage, HELOCs, installment loans, student loans, and car loans. Your credit mix accounts for 10% of your FICO Score. If you are successfully managing a variety of financing types, it will be reflected in your FICO Score. After you pay off a car loan, your credit mix decreases, and your credit score may dip as a result.
New Credit Card Applications
When you apply for a new credit card, the provider will do a hard inquiry on your credit score that could cause it to dip slightly. A new account will reduce the average age of your accounts, which could also lower your score.
On the other hand, a new credit card account will increase the amount of credit available to you, which might lower your credit utilization rate. It might also diversify your credit mix, and if you make payments on time, it could build a stronger payments history.
Recommended: 8 Reasons Why Good Credit Is So Important
How to Pay Off Debt and Help Your Credit Score
Paying off debt should boost your credit score, but in some cases, it can damage it. For example, if you pay off debt and close credit card accounts, you may not be able to demonstrate to the credit bureaus that you make regular payments and practice responsible fiscal management.
Here are some ways to pay off debt that are unlikely to lower your credit score.
• Pay due amounts on time. Your payment history is the most important component of your credit score. You can improve it by paying off your credit card balances in full each month and also paying your mortgage on time.
• Pay off high-interest debt. High-interest credit cards can trap you in a spiral of debt if you don’t pay off the balance each month. Pay off these cards first so you reduce the likelihood that you will fall behind on payments and rack up interest charges. This will benefit your credit score because lenders will consider you less of a risk.
• Pay off debt with cards with low credit limits. If you are maxing out the credit limit on a card with a low credit limit, your credit utilization rate may be high because you have more debt than you have accessible credit. That makes you a high risk to a lender and will reduce your credit score.
Try to keep your credit utilization rate below 30%, and ideally around 10%. By paying off credit card debt with a low credit limit, you reduce your debt load but maintain access to the credit, improving your credit utilization rate.
• Pay off your student loans (maybe). Paying off your student loans may or may not be beneficial. It will reduce your debt-to-income ratio; however, regular student loan payments contribute to a healthy payment history. Also, student loans add diversity to your debt mix, so paying off this type of installment loan might negatively impact your credit score.
• Pay any past-due bills. Paying off old debts that are late shows lenders that you pay what you owe. Pay the most recent bills first.
How Do I Keep My Credit Score From Dropping?
Practicing good fiscal management will help keep your credit score from dropping. Keep in mind that closing old credit card accounts and paying off some debts may backfire. Maintain a credit utilization rate that’s below 30%, and most importantly, pay your bills on time.
How Long Does It Take for Your Credit Score to Improve After Paying Off Debt?
Paying off debt may not necessarily improve your credit score, and your score may show a decrease initially. However, in most cases, your score should reflect a better credit utilization ratio in one or two months.
Keep in mind that a car loan has no impact on your credit utilization score.
Recommended: How Often Does Your Credit Score Update?
Ways to Increase Your Credit Score After Paying Off a Loan
If your credit score dropped when you paid off a car loan or other loan, do some research to find out why. Then, there are various things you can do to remedy the situation and build back credit.
• Avoid late payments. Setting up automatic payments and using a spending app can help you to avoid missed payments.
• Check your credit utilization rate. Check that by paying off a debt and closing an account, you have not raised your credit utilization rate to over 30%. Aim to spend no more than 10% of your total available credit.
• Avoid closing out older credit accounts. Keep older credit accounts open, even if you never use them. This will lengthen your credit history.
• Limit new credit inquiries. Be careful when shopping for new credit cards or loans. Hard inquiries by lenders within a short period (around 14 days) will lower your credit score. Try to find lenders that will prequalify you for financing without a hard inquiry.
• Improve your credit mix. Try to use both credit cards and installment loans responsibly by making regular, timely payments.
However, remember that a variety of loan types will only have a small impact on your credit score. It’s not advisable to take on extra debt just to fulfill the need for a diverse credit mix.
How to Monitor Your Credit Score
When it comes to credit score monitoring, you have plenty of options.
Federal law allows you to view a free copy of your credit report from each of the three national credit bureaus (Experian, TransUnion, and Equifax) at AnnualCreditReport.com.
You can also use a credit score service. Some sites provide a free credit score to users. Others may provide credit scores if you pay a monthly subscription fee.
Some credit card companies, banks, and lenders have started to provide credit scores for their customers. Check your statement, or you may be able to access it online after logging into your account.
If you find information you believe is inaccurate or incomplete on your credit reports, you can also file a dispute with the credit bureau that provided the report.
The Takeaway
Paying off a loan, such an auto loan, can have an unexpected negative effect on your credit score. This may be because of a decrease in your credit mix, a change in the length of your credit history, or another factor that contributes to your credit score.
It’s important to monitor your credit report and your credit score and understand why any changes occur. That way, if your credit score drops, you can take steps to remedy the situation, such as paying off the balance on credit cards, improving your credit mix, and watching that your credit utilization rate stays below 30%.
Take control of your finances with SoFi. With our financial insights and credit score monitoring tools, you can view all of your accounts in one convenient dashboard. From there, you can see your various balances, spending breakdowns, and credit score. Plus you can easily set up budgets and discover valuable financial insights — all at no cost.
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FAQ
Why did my credit score go down after paying off my car?
If you pay off a car loan, the loan will remain on your credit report for up to 10 years, and as long as you always make your payments on time, the loan will continue to have a positive effect on your credit history. If you remove that loan, your current credit standing could worsen because you have less of a credit history.
How long does it take for your credit score to go up after paying off my car?
In most cases, your score should go up in one or two months if other factors do not come into play, such as a limited payment history or closing an unrelated credit account.
Why is my credit score going down even though I pay on time?
A change in your credit history could cause your credit score to drop. For example, if you apply for new loans or credit cards within a short timeframe, the hard checks conducted by lenders may cause a temporary drop in your score even if you don’t sign for the loans. Also, if you close out old credit cards, you could be shortening your credit history, which will lower your credit score.
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