According to the US Consumer Financial Protection Bureau, credit card debt began trending downward in 2021 for the first time in several years. Perhaps you are one of those who worked hard and finally paid off your debt. Congratulations! Then suddenly you notice a dip in your credit score. This can be confusing and even frustrating. Let’s take a look at a few reasons why this could happen.
Four reasons why my credit score dropped after paying debts
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.
Credit utilization
Credit utilization is the total ratio of debt to total credit available. Most guidance suggests it is best to keep this ratio below 30%. For example, if your credit card limit is $5,000, you may want to consider letting your balance get no larger than $1,500. You could do this by paying off the full balance that you charge to the card every month, or at least paying more than the minimum charge, to help lower your costs.
Though there is no exact formula for credit utilization, the idea is that as a borrower you can use your credit and manage your card use.
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.
Keep in mind that credit agencies look at your entire credit profile when determining your credit utilization. This means you do not have to use all your credit cards. Using at least one ensures you have some sort of credit utilization. Additionally, keep in mind that having balances on all of your cards also affects the utilization and can make it more likely to get above that 30% mark.
Low credit mix
Credit mix refers to the types of credit accounts you have open. For example, you can have personal loans, a mortgage, credit cards, and a car loan. This is considered a diverse credit mix. If you pay off a car loan and leave only a credit card on your credit, this reduces your credit mix and, ironically, can lower your score.
If that happens, you can consider adding another type of credit into the mix to help boost your score. Credit Builder Plus is a great option. Becoming a member could help diversify your credit mix while also giving you access to credit monitoring resources.
Closing an account
Some might assume that paying off and then closing an account is the best way to help your credit. But this may be one of the best ways to see your credit take a dip. If you close a credit account, any existing debt on other accounts will suddenly take up a larger proportion of your credit portfolio. At the same time, your remaining debt will cause your credit utilization to increase.
For example, let’s say you have four credit cards, each with a limit of $500. You have a card that you use often and that card currently has a balance of $250. You might think, “Well, I don’t use the other three so let’s close them.”
In doing this, your total line of credit goes from $2,000 to $500. And your credit utilization goes from 12.5% (250/2,000) to 50% (250/500)! This could cause your credit score to drop significantly. If you can, keep your accounts open, especially accounts that you have had for a long time.
You applied for new accounts
New accounts are great but keep in mind that inquiries about your creditworthiness can cost you some credit points. When you apply for credit, whether it is a new credit card or a loan, an inquiry is performed. A hard inquiry, or a credit check, is typically done when you are actually applying for new credit.
Hard inquiries typically cost you the most points. Though this is part of the credit game, be mindful of how many hard inquiries you have in a short time frame. Too many can be concerning to creditors. Also, keep in mind that the older your accounts are the better it looks on your credit. Keep up with payments to those accounts that you have had for several years. It is a sign to creditors that you understand how credit works.
It also shows longevity, which is important because creditors also want to see that borrowers are experienced with using credit. Experienced borrowers know how credit works. They are more likely to know how to borrow within their means and 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.
Maintaining your credit score in four simple steps
Once you get your credit score where you need it, the next step is to make sure you maintain it. Here are some simple steps that may help maintain your credit.
- Keep accounts active and open
Part of maintaining your credit is keeping your existing accounts open and active. The older your account is, the better your credit score. Try to hang on to those older accounts, even with minimal use. Keeping the accounts active helps show that you can maintain your credit and at the same time increases the average age of your credit.
- Maintain a 30% credit utilization
Credit utilization plays a huge role in maintaining your credit score. Try to keep your utilization below 30%. This can be hard to manage or even keep track of sometimes. Fortunately, with a Credit Builder Plus membership for $19.99 a month, you have access to expert credit advice, the Financial Heartbeat, and information about your credit score and utilization.
- Always pay bills on time
Though it can be hard at times, it is important to stay on top of your monthly payments. Your payment history has a major impact on your credit score, specifically if your payments are late. In fact, a single late payment can negatively affect your credit score, and payments that are 60 or 90 days late can really hit your score.
- Avoid unnecessary checks
Cutting down on hard inquiries, especially if you have a low credit mix, can help keep your credit score higher. Hard inquiries include things like applying for a credit card after receiving a pre-approval, opening a new service such as for the internet or a cell phone, and applying for a mortgage. Just be mindful of how many credit checks you get done in a year.
Stay on top of your credit
Credit can be confusing. You build it up and sometimes your score can take a drastic drop. However, if the choice is either your credit score dropping after paying off a loan or keeping the loan, it might be better to pay off the loan since the drop could be temporary, and there are great ways to get your credit back up pretty quickly.
With MoneyLion Credit Builder Plus membership, you get access to credit monitoring, which can help you stay on top of your score. You can look at your credit utilization and score while also tracking your progress and getting regular customized tips.
Dips in your credit score can happen, but knowing when and why helps makes the drops a little easier to manage
