A homeowner celebrates the day she pays off her mortgage, but finds out the following month her credit score has dropped.
A recent college grad makes the last payment on his car loan, only to discover a few weeks later his normally excellent credit scores have seen a drop.
Why did these two financially responsible people see their scores decrease after paying off their debt?
Credit experts will tell you maintaining a good credit score is all about keeping your balances low in relation to your credit limits (“low utilization”) and making your payments on time.
If you start to max out your cards and make late payments, your score will dwindle into a financial corpse.
Credit scores are supposed to help business understand the amount of risk you pose as a borrower. So, it makes sense that your scores would drop if you maxed out your cards – you must be in some kind of financial trouble or you can’t manage your money.
It also is perfectly sensible that your score would drop if you make late payments. No lender wants to deal with the hassle of someone who never pays on time – it’s a risk.
But why would scores drop for the two people we mentioned? Are there other unknown ways our scores can drop?
To Know Why Scores Drop, You Have to Know How You’re Scored
Credit scoring agencies like FICO use algorithms (math equations) to determine someone’s credit score. They combine several different factors, two of which make up 65% of your score: payment history and utilization rate.
Late Payments Make a Big Difference
I’ll share an example from my own life to show you how much late payments can affect your credit scores.
Back in 2010 I made the embarrassing mistake of not renewing a financial hardship on my student loans. For three months, my accounts were overdue. As a result, my credit history showed multiple 90-day delinquencies.
This past year, I did the hard work of petitioning Equifax, Experian and TransUnion to remove those late payments from my credit history.
Fortunately, since the companies who reported those delinquencies are no longer in business, the bureaus were forced, by law, to remove the late payments. It’s a loophole that only works for certain borrowers.
Once all of the late payments were removed, my scores jumped up more than 20 points.
Lowering Balances Helps
In another personal example, I moved some credit card balances around earlier this year specifically so each of my cards would have a balance of less than the suggested rate of 30% of my overall credit limits. Once again, I saw my scores jump, this time between 10 and 15 points.
Now, these are a pair of examples in which I did the work of repairing the two most important factors in my credit scores. The simple fact that I could manipulate the scores – granted, it took a lot of research to make my 90-day delinquencies disappear – makes me think the system isn’t as airtight as people make it out to be (more on that later).
But what about the examples I mentioned in the beginning of this article? Why would those scores drop?
What Makes Your Scores Go Down?
To get to the bottom of this question, we put Ben Woolsey, president and general manager of CreditCardForum, to the test.
Ben’s website is a go-to resource for in-depth information about the credit industry, but it’s also a fantastic place to participate in lively forums about credit scores and credit in general.
1. Not Using Your Credit Cards Can Drop Your Credit Scores
One of the most interesting things Ben told us is that credit is like a muscle – your credit scores will get stronger the more credit you use.
“Credit is sort of like a muscle,” Ben said. “You have to exercise it to keep it healthy and strong and exhibit responsible behavior consistently over time. You can’t just walk away from the credit market.”
After the Great Recession, consumers were afraid of getting into debt and skeptical of hidden terms and conditions included with credit cards. So, Ben told us, there was a decent chunk of consumers who put their credit cards away and started using debit cards.
Wise choice, right? Using a debit card means you don’t have to worry about late fees and APRs. Plus, you’re pretty much guaranteed not to spend more than you have.
But, to creditors and credit bureaus, ditching your credit cards makes it look like you’ve “stepped out of the credit market, to some extent,” Ben said.
And when you aren’t using credit, then your credit habits become a mystery. Are you responsible? Are you flighty and flaky? Creditors and credit bureaus have no idea.
As a result, your scores will suffer. The unknown, is, for the most part, seen as a risk rather than an indication that you’re responsible.
This is, in a roundabout way, another example of why payment history matters. You see, payment history isn’t just about paying on time. You also need to be paying down debt on a regular basis – the more payments you make, the more responsible you seem.
2. Paying Off Loans and Mortgages Can Drop Your Credit Scores
When you pay off a mortgage, it’s a relief because you’ve just opened up, in most cases, more than $1,000 in extra income each month. What better example of financial freedom, right?
But, as far as the people who formulating your credit scores are concerned, you’ve just ended a payment relationship that proved you were responsible. The same principle is at work for auto loans or personal loans.
We can’t provide you a definite answer for how much your scores will drop when you no longer have a loan, but we did a little research to see if other credit experts could predict the impact.
According to Equifax, it’s hard to pinpoint a number because your Equifax score is made up of many different factors. However, the credit bureau said, the impact on your score is likely to be minimal.
“Paying it off could have a slight negative impact on your credit score, but the impact would likely be minor,” Equifax’s experts wrote.
While we think it’s counter-intuitive to see your score drop when you’ve done something responsible like pay off your mortgage, we realize there’s a bigger picture at stake. I’m going to use a baseball example to explain it.
Let’s say you play outfield for the Chicago Cubs and your batting average is .250 after 100 at-bats. For the next 100 at-bats you are on fire, notching 50 hits. Your batting average goes up from .250 to .375. The streak tires you out, though, and you go hitless in your next 10 at bats. Your average drops from .375 to .357.
Even though you saw your average dip at the end of that hitless streak, the work you put in before that bumped up your average so high that the small drop wasn’t that big a deal because your batting average is still more than .100 higher than it was before you went on your streak.
The same goes for your credit score dropping after you pay off your mortgage. Yes, it dips, but your score went up so much because you made 30 years of on-time payments that the small drop barely dented your now-amazing score.
3. Not Paying Credit Cards on Your Statement Closing Date Can Drop Your Credit Scores
This final way your score can drop is something you’ll rarely read about. To help you understand it, I’ll use another example from my own life.
My wife and I use the Hyatt Visa to make our monthly purchases for gas, groceries, entertainment and miscellaneous purchases. We pay off our balance every month on our billing date.
However, when we check our credit scores, they show the balance of our Hyatt card before we pay it off.
This is because many credit card companies report the balance you have on your statement closing date, not the due date for your payment.
So, if your statement closing date is the 22nd of each month, your credit company reports the balance on that exact day. If you pay your balance on the 22nd, then your credit score will reflect that. But if you pay off your balance in the weeks following your statement closing date, your score will reflect that.
“Since your statement closing date occurs before your actual due date, you should change your budget so that you pay off the card in full by the statement closing date,” Michelle says.
“If you follow this strategy then your credit cards will always have a $0 balance reporting on your credit reports - a win for your credit scores.”
Experts Weigh-In on the Effectiveness of Credit Scoring Systems
One of the things we’ve learned during our research for this article is that credit scoring systems aren’t perfect. Why penalize someone who paid off a mortgage?
Sure, the damage is minimal, but is it beneficial to the consumer when an algorithm thinks you’re more of a risk because you ended a 30-year streak of payments?
In our opinion, that seems a little arbitrary, especially when you pair it with other inconsistencies we’ve experienced.
For example, moving my balances around to make sure no single card is over 30% of its credit limit doesn’t mean I’m less of a risk, right? It just means I know how the scoring works and I adjust my balances accordingly.
From our perspective, that seems awfully arbitrary for an entity – credit scores – that can make a huge difference in interest rates on credit cards, auto loans, and mortgages.
So, we asked experts about their thoughts on the credit scoring system. Does it work like it’s supposed to or is it broken?
Definition of “Credit Risk” Could Be Improved
Ben Woolsey admitted the system isn’t perfect, pointing to someone who paid off a mortgage, for example, as a person who may not be a credit risk but is penalized as such.
“I think these models aren’t perfect. They try to approximate risk, but they have some blind spots,” Ben said. “For someone who has stable income and who’s paid off a financial obligation over time, just because they’ve retired a type of debt that shouldn’t be correlated to an increased risk.”
Ben is a proponent of good credit, so don’t think of him as a crusader against the credit-scoring system. He acknowledges the system is based on solid principles of timely payments and low utilization.
However, he does bring up a good point – penalizing someone for fulfilling an obligation shouldn’t mean they’re more of a risk.
Wrong Information Plagues the System
A 2012 study from the Federal Trade Commission revealed that one in five credit reports have errors on them. Those errors resulted from credit reporting agencies (credit card companies, student loan lenders, etc.) sending wrong information.
Jeff Neal from JasonCouponKing.com said the problem isn’t so much the concept of a scoring system, but that credit bureaus factor in information that may be incorrect.
“A wrong address or middle name isn't a big deal,” Jeff said. “But when they post inaccurate late payments or other damaging information, that’s when it has a negative effect.”
That makes us wonder – why don’t credit bureaus and credit reporting agencies validate damaging information with the consumer before altering a credit score?
Anyone who’s had to go through the painstaking process of correcting bad information knows it’s a lot of work and a lot of stress.
Cutting down on those situations by verifying information would not only help credit bureaus post accurate scores, but it would help consumers have control over misinformation that could potentially cost thousands of dollars in higher APRs.
People Who Take on More Debt Are Rewarded
Another peculiar aspect of credit scoring systems is it seems like consumers are rewarded for taking on more debt. If you pay off a loan, your score takes a minor hit. But if you take on more debt – whether you pay it off at once or over time – your score slowly goes up.
We aren’t the only ones who noticed this. Brad Kingsley, financial coach and co-founder of MaximizeYourMoney.com, pointed this out to us.
“The current credit scoring system – that is based solely on debt metrics – is broken and far from an accurate representation of someone’s financial standing,” Brad wrote. “The FICO scoring system rewards people for taking on more debt, different types of debt, and using the debt.”
What we find so fascinating about this is that the credit scoring system’s bias toward people with debt presents a huge benefit for credit card companies.
We’re not saying there’s any sort of conspiracy, but credit card companies aren’t exactly complaining when the average credit card debt of people who don’t pay off their balances is more than $16,000.
According to FICO and other credit scoring systems, that debt is “good” for your credit scores as long as it’s not above 30% of your overall credit limit and you make payments on time each month.
Meanwhile, consumers who want to get rid of their debt work hard to pay off their balances. Good for them, too; scores of financial experts say being debt-free is the first major step to financial freedom.
Yet when you finally pay off that last bit of debt, FICO and other companies see you as more of a risk. It just doesn’t make sense.
“People who either are paying off debt, or have already paid off debt, actually wind up with a lower credit score and – per FICO – are higher financial risks,” Brad wrote.
“Someone with a million dollars in the bank and no debt (could) have a worse credit score than someone with no savings at all, high levels of debt, and potential monthly cash flow struggles.”
Credit Scoring Agencies Aren’t Oblivious to Their Inconsistencies
While we’ve pointed out some of the flaws of credit scoring systems, we do acknowledge that FICO, for one, is aware of the quirks of their system.
In a 2014 article from The Wall Street Journal, reporter Annamaria Andriotis talked about FICO’s decision to tweak its scoring system by reducing the impact of accounts that went to collections but were paid, and medical bills that went to collections.
These changes could result in credit scores rising as much to 100 points, in some cases, credit expert John Ulzheimer told Andriotis.
John Ganotis, founder of CreditCardInsider.com, mentioned that FICO adjustment as he talked about why the credit scoring system is, for the most part, an accurate measure of consumer risk.
“Credit scoring models certainly aren't perfect, but they help lenders efficiently screen risk,” John said. “Companies that develop them are constantly iterating to improve scoring models and competing with one another to provide a better assessment of risk that corrects issues seen in previous models.”
Bottom Line Why Credit Scores Drop
Your credit scores can take a dip for a number of well-known and not-so-well-known reasons. Paying your credit card or mortgage more than 30 days after the due date is guaranteed to drop your scores, so pay on time. Also, maxing out your credit cards will kill your scores.
More subtle ways of dropping your scores include not using your credit cards, paying off mortgages and other types of loans and not paying off your credit card balances by the statement closing date.
Bad information can have a big effect on your credit history, too, so make sure you sign up for a free credit-monitoring service like what Credit Karma offers. You’ll receive alerts when your credit score changes, and you’ll get an updated score every few days.
As for whether or not credit scoring systems are fair, all we can say is that most experts acknowledge the system isn’t perfect but is effective. What’s our opinion on the matter?
We aren’t so much concerned about the effectiveness of the system – it’s pretty solid – as we are about how consumers can make sure that system is working for them.
To do that, you need to pay your credit and loan accounts on time every month and you need to make sure your credit-card balances stay under 30% of each card’s credit limit.
Check your credit history every week for errors. If you discover mistakes, contact the reporting company and find out what happened.
If they acknowledge the error, make them put it on paper and send it to you. You can then use that documentation to start a dispute with credit bureaus, two of which (Equifax and TransUnion) you can start the dispute process with through your Credit Karma account.
In the meantime, don’t leave our site without reading through some of our credit score guides. We’ve written a trio of easy-to-read articles about how credit scores came into being, what you can do to get a good score and how you can repair a bad score.
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