It may seem like an error — your credit score dropped after paying off debt. Unfortunately, it might not be an error. Even if you’re completely debt-free, your credit score can take a hit due to certain factors.
Luckily, you can bounce back from a credit score impact. The first step is identifying why your score dropped, and then you can take steps to ensure that it doesn’t fall any lower and to build it up.
Reasons Your Score Dropped After Paying Off Debt
Many aspects of your financial life are considered by the agencies that determine your credit score. Negative activity in any one of these areas could impact your score.
When it comes to credit utilization — the ratio of debt to total credit available — a commonly cited rule of thumb is to keep it below 30%. For example, if your credit card limit is $1,000, you should avoid letting your balance get larger than $300. However, you don’t want to stop using your credit card altogether.
The exact formulas that credit scoring agencies use is a closely guarded secret, but experts suggest that these agencies are looking to ensure that borrowers can use credit without abusing it.
If you don’t use your credit card at all, creditors might worry that you’ll forget to pay your bills when you finally do use it. But if you regularly build up and pay off small amounts of debt, it signals to creditors that you are in the habit of tracking your credit usage and making payments on time.
You don’t need to use every credit card you have to avoid 0% credit utilization. Credit agencies take your entire credit profile into account, so as long as they see some activity in at least one of your accounts, your utilization won’t be 0%.
You Closed the Account
Aside from excessive shopping sprees, nothing spikes your credit utilization quicker than cutting off a line of credit entirely. If you close a credit account, any existing debt on other accounts will suddenly take up a larger proportion of your credit portfolio.
For instance, imagine that you have three credit cards, each with a credit limit of $1,000.
You primarily use one card, and that card has a current debt balance of $750. You decide, since you hardly use the other two cards, you might as well close one of them.
However, in doing so, you’ve cut your total line of credit from $3,000 to $2,000. Your credit utilization suddenly goes from 25% (750 ÷ 3,000) to 37.5%, and your credit score takes a hit.
You Applied For New Accounts Right Away
With the last point in mind, it might seem like applying for a new account should be good for your credit score. You’re increasing your total line of credit, right?
When you apply for a loan, credit card, or any other form of credit, the creditor will perform a hard credit inquiry (also called a “credit check”) on your credit score. As opposed to a soft credit inquiry, hard inquiries signal that the borrower is actively looking for new credit. Multiple hard credit checks in a short timeframe could signal desperation for money. That’s a worrying sign to creditors, and your credit score will drop as a result.
Creditors also want to see that borrowers are experienced with using credit. Experienced borrowers know how credit works. They borrow within their means and they pay off their debt on time. Credit agencies average out your age of credit, so opening a new account is a heavy drag on any other experience you’ve built up, especially if you don’t have many other accounts.
How to Maintain Your Credit Score
Now that you have an idea of why your credit score dropped, let’s look at ways you can maintain it — or even increase it.
Keep Accounts Active and Open
Every year that you maintain all your credit accounts without opening a new one, your average age of credit increases. The older your average age of credit, the better your credit score, and the smaller the negative impact of opening a new account.
Keeping all your accounts open also ensures that you are maintaining the maximum line of credit possible, which allows you to borrow more without overextending your credit utilization.
Maintain a 30% Credit Utilization
As mentioned above, the general rule of thumb when it comes to credit utilization is 30% or lower. Credit card companies can reduce your credit limit at will, so it may be best to play it safe and keep your credit utilization well below 30%.
Remember, as long as you keep all of your lines of credit open and use at least one of them every month, you’ll avoid getting dinged for 0% credit utilization.
Always Pay On Time
Your payment history impacts your credit score. Creditors want to see that you can honor your promises to repay debt in a timely fashion – setting autopay is key in this step. Any payments made more than 30 days late will likely hurt your score.
Payments that are 60 or 90 days late could take an even bigger hit on your score. To avoid those negative impacts, keep up with your payments.
Do What It Takes to Improve Your Score
Regardless of why your credit score dropped, it’s important to rebuild it. Your credit report impacts many aspects of your life, including your ability to get a loan, buy a home, or even get a job.
MoneyLion offers multiple tools to help you build your credit, including the Credit Builder Loan, which can raise your credit score by 60 points in just 60 days.
Building credit is a slow process, and you won’t go from bad credit to good credit overnight. However, with patience and persistence, your credit score can recover from any major slip-ups.