Your credit score goes up when you show that you’re financially trustworthy. One day you pay off a loan and notice that your score drops. Shouldn’t your credit score have jumped up, instead? To understand what’s happening, take a look at how credit scores are calculated:
Credit Reports and Scores
The three credit reporting agencies, Equifax, Experian, and TransUnion, all collect and report information about your credit history. When a lender considers your trustworthiness, they order a report from each agency. In addition, they order a credit score. A credit score is a number that summarizes all the information in your report to expedite the approval process.
Fair Issac Corporation (FICO) is the go-to score calculator for 90 percent of lenders. (VantageScore is also used, but it’s much less common.) FICO provides a number of different models and scoring methods that are each used by lenders in different sectors. The most commonly used method is FICO Score 8.
Components of a FICO Score
There are five components to a FICO score:
- Payment History
- Amounts Owed
- New Credit
- Length of Credit History
- Credit Mix
Each of these components weighs different sub-factors. To answer our initial question about how a paid off loan can make your credit score drop, we need to look in the Amounts Owed and Credit Mix categories.
Credit Mix analyzes how well you employ the two “kinds” of credit available to consumers: revolving and installment. Revolving credit refers to credit cards, where you borrow and repay frequently. Installment credit refers to larger loans that you pay back over time, like auto loans. If you only have one or the other, your Credit Mix score drops. Having “open” installment credit, like a loan you are still paying off, will give you more points here than a loan completely repaid.
Amounts Owed is where it gets tricky. Part of this component is often referred to as “utilization,” which is the ratio of how much of your available credit you’re using. For installment credit, it’s calculated as what you currently owe on installment loans, divided by the amount you borrowed. For example, if you took out a loan for $5,000 and still owe $4,000, your ratio is 4/5 and you won’t get many points. However, if you only owe $500, your score will go up. The kicker: “utilization” only counts when you’re “utilizing.” If the loan is paid off and the account is closed, you won’t receive any points here.
Still Seems Odd, Huh?
Even with that explanation, it’s still counterintuitive that a repaid loan isn’t worth as many points as a loan that’s almost paid off. However, if you’re paying off your credit cards and you just paid off a loan, your credit is probably in the 700s or high 600s, which is good! Think of it like this: which car would you trust more? One that ran well a week ago, or one that’s running well today? The car that ran a week ago, you assume is still good, but the car that drives well today you know is great. That’s how the score looks at your payment history: if you’re currently making payments on loans and credit cards, you’re a safe bet with a higher score.
Do You Need to Do Anything to Raise Your Score?
Before you rush out to take on a new loan so you can “be the car that’s running today,” consider that there are other types of FICO scores. In mortgage lending, FICO Scores 2, 5, and 4 are used instead of FICO Score 8. A lender may also look at your VantageScore, which is calculated similarly. Don’t pay interest on a loan you don’t need just to max out your score—credit isn’t a video game.
If you’re still left with questions, now is a great time to dig into your free credit reports from federally authorized annualcreditreport.com!