Why did my credit score drop after paying off debt?

Dear Keeping Score,

I paid off my Amex balance and TransUnion lowered my score -41 points. Credit card utilization went from 84 percent to 1 percent. Why did my score go down? I also paid off the balance on my Capital One card and Home Depot credit. Will TransUnion lower my score even more once those last two report in? — Andrew

Dear Andrew,

Don’t we all wish that the world of scoring was that simple? Push button A and your score goes up, push button B and it goes down. In the real world, scores are built from complex algorithms that are able to predict more than even the trained eye can see.

Still, that doesn’t seem right, does it? Here you are, doing what seems to be all the right things, and you get penalized! Let’s examine this a little closer to see if we can figure out what’s happening.

Why paying off debt can hurt your credit

It seems counterintuitive, but paying off debt can hurt your credit. Here are a few scenarios for you to consider:

Does your Amex account have a set credit limit? Some Amex cards work like traditional revolving credit cards — offering a set credit limit and affecting your credit utilization ratio as such. But other Amex cards don’t have a set credit limit (instead allowing you to enroll in Pay Over Time for select qualifying purchases if you need to carry a balance.) Without a predetermined limit, these cards won’t affect your utilization ratio. If this applies to your Amex card, the 41-point drop could be from something else.

Did you close your account? If you close a revolving account once you pay it off, it could hurt your score because it will lower your total credit limit. If you did (or you closed any other account), that would account for the drop since your total credit limit across all your credit cards is factored into your credit utilization ratio.

Do you have a very high score to begin with? Any changes in your credit behavior can adversely affect a high score, at least in the short term. If you dropped 41 points from an 840 to a 799 there is actually no practical difference between the scores.

There could be additional reasons why your score dropped that don’t necessarily mean your credit is in trouble. For instance, it could take 30 days for your lower balance to show up on your credit. If it hasn’t not been that long, give it time. The 41-point drop could be a result of your previous 84 percent credit utilization ratio.

Lastly, it is always good to keep in mind that you have multiple credit scores, and each one is unique. If the two scores you are seeing come from different lenders or third-party websites, the drop could have nothing to do with your credit habits. It might just be a result of different scoring models.

FICO scores and VantageScores use similar information to calculate credit scores, but the information is weighed a bit differently. So the score you see through a third-party website will likely be a little different from the one a lender uses.

How long does it take for credit scores to change after paying off debt?

After you pay off a debt, it can take anywhere from 30 to 45 days to reflect the payoff on your credit report. The delay between paying off your debt and it showing up on your credit report is due to the lenders’ monthly reporting process and credit card and loan billing cycles.

The positive effect that you may get from paying off debt typically impacts your credit score between one to two months after the debt payment is made, but a positive impact is not always guaranteed. In some cases, your credit score may temporarily drop after you pay off what you owe. But it’s typically just an initial drop and is generally limited to those who close an account or whose account is closed by the lender after the debt is paid off. For others who pay off their debt and keep their account open, however, paying off debt should result in an increased credit score.

How to pay off debt

Paying off debt, in my humble opinion, is one of the best things you can do for yourself. It’s certainly a good move for your financial health, and I believe that will help your overall health, too. When the time comes to pay off a debt — whether it’s revolving debt (like a credit card) or an installment-type loan (like a car payment) — you should know that you’re doing the right thing for yourself, and your score will reflect your good behavior in the long run.

Here are some of my favorite debt reduction techniques:

• Set a fun goal — Paying down debt may not be fun, but it is always easier if you are doing it for a specific reason. Making a plan for the money you eventually free up can help motivate you to pay it off quicker.
• Determine a time frame — Take a look at your budget and determine how much you can reasonably put toward your debt each month. Then, using a debt calculator, you can set a definite date to dump the debt.
• Make it automatic — Once you decide how much you can put toward your debt each month, set up monthly automatic payments to keep yourself on track.

And remember that when it comes to credit cards, it’s best not to close them unless there is a good reason to do so (like an annual payment that you think is too high or poor customer service). If the card carries a high interest rate and you believe that’s a good reason to close it, I would suggest you use the card only for purchases you can pay in full each month, or just put it in a drawer and get a new card with a lower or zero introductory APR for other purchases. That’s a win-win in my book.

How to increase your credit score

If you decided to pay off your debt and it impacts your credit score negatively, there are steps you can take to try and get your score back in shape. To increase your credit score after paying off debt, it may be helpful to consider these steps:

• Make consistent and timely payments on all accounts to avoid any late payments damaging your credit.
• Diversify your credit mix with both installment loans and revolving credit.
• Reduce your credit utilization ratio to less than 30 percent, and ideally less than 10 percent if possible.
• Seek out new credit that can increase your total pool of credit or add diversity to your portfolio.
• Maintain a minimal balance on credit cards to show responsible use of your credit and try to avoid closing old credit card accounts unless annual or monthly fees make it too expensive.

Remember to keep track of your score! To monitor your progress with increasing your credit score, it may be helpful to sign up for credit monitoring services, which will alert you to changes that occur to your credit score.