Whether you recently repaid a loan or are starting a plan to reduce your debt, there are a few things you should know. First, do a happy dance for achieving or taking steps toward reaching a financial goal. (Pause for happy dance. OK, continue reading.) Second, understand what paying off debt means for your credit profile.
“There is this misconception that you have to carry debt in order to have a great credit score, and that’s not true,” said Gerri Detweiler, Credit.com’s director of consumer education. Eventually, an inactive account will no longer impact your credit scores, but such information stays on a credit report for about 10 years and will continue to contribute to your scores throughout that time. But once that time is up, you lose that history.
Effects of Repaying Debts
To be clear, paying off debt is generally a very good thing. Once you fulfill that financial obligation, you can put the money you normally set aside for payments toward other debts or savings, and you can enjoy the gratification that comes with paying off debt. By cutting down your outstanding balances, you can lower your ratio of debt to available credit, and a low credit utilization rate will help your credit scores.
Detweiler says older consumers are more likely than others to see a negative effect from paying off debt — perhaps they’ve paid off their homes and cars or don’t use credit cards. After older accounts are no longer on their credit reports, they may find themselves with little credit history and low credit scores as a result.
Maintain a Strong Credit History
To have a good credit score, you should use credit — it’s the best way to add to your credit report, on which credit scores are based. Even if your house or car is paid for, how much you pay for things like homeowner’s insurance and car insurance may still be tied to your credit scores, which is why you may want to continue working on your credit history. The important thing is to make sure you use credit in a way that makes sense for you financially.
“It’s not a great idea to take on debt just to build your credit scores,” Detweiler said. However, using a credit card and paying it off every month is a way to maintain credit without paying interest, and 0% financing offers could also help in a similar way.
You can see how all these factors contribute to your credit scores by regularly looking at the same scores and comparing changes over time. For instance, the free Credit.com Credit Report Card gives you two scores used by lenders — an Experian score and VantageScore 3.0 — every 30 days and shows you how certain behaviors, like payment history and credit utilization, impact those scores. There are dozens of credit scores out there, many are educational and some are used by lenders, but it’s most helpful to look at the same one each time in order to gauge changes, because various models weigh things differently.
And that’s something to keep in mind: There are a lot of things that go into your credit scores. Sometimes there’s no rush to pay off debt. For example, if you have a low interest rate and have other financial goals to work toward, throwing a lot of money at a debt may not make the most sense. Paying off debt slowly can help you establish a strong payment history (as long as you make those payments on time), as well as avoiding future debt by saving money to buy a home or get an education.
Bottom line: Paying off debt does not cause a drop in credit scores, Detweiler said.
“As long as you don’t close out credit cards after you pay them off, you shouldn’t see a negative impact.”
More on Managing Debt:
- The Credit.com Debt Management Learning Center
- How to Pay Off Credit Card Debt
- 5 Tips for Consolidating Credit Card Debt
- Understanding Your Debt Collection Rights
- The Best Way to Loan Money to Friends & Family
- Top 10 Debt Collection Rights