Welcome to the “2-Minute Money Manager,” a short video feature answering money questions submitted by readers and viewers.
Today’s question is about credit scores; specifically, why instead of rising, your score sometimes can actually drop after paying down debt.
Watch the following video, and you’ll pick up some valuable info. Or, if you prefer, scroll down to read the full transcript and find out what I said.
You also can learn how to send in a question of your own below.
For more information, check out “How I Got a Perfect Credit Score in 4 Steps” and “7 Credit Score Myths: Fact vs. Fiction.” You can also go to the search at the top of this page, put in the words “credit score” and find plenty of information on just about everything relating to this topic.
Got a question of your own to ask? Scroll down past the transcript.
Don’t want to watch? Here’s what I said in the video
Hello, and welcome to your “2-Minute Money Manager.” I’m your host, Stacy Johnson, and this answer is brought to you by Money Talks News, serving up the best in personal finance news and advice since 1991.
Today’s question comes from Lauren:
“I recently paid off the last of my credit cards — something I’m proud of, and that took me years of effort. I assumed that after paying everything off, my credit score would rise (it was about 700) but instead it went down 20 points. Not fair! Am I being punished for being responsible?”
First and foremost, Lauren, congrats on paying off your debt. The credit score nerds may not be showing their admiration, but I certainly will. Living debt-free is a major step along the path to financial freedom. It’s an awesome accomplishment. Congratulations!
Now, let’s address your question.
You’re absolutely right, Lauren: It certainly looks like you’re being punished for being responsible. Why is this happening?
To understand, we’ll have to look under the hood and see how credit scores work. Not to worry, though: I’ll make it quick.
Here’s the deal. Your credit score is made up of several components. One is your payment history — that’s the biggie. But your score also takes other stuff into account, like credit utilization, the length of your history and the types of credit you have.
Credit utilization is just a fancy term to describe how much credit you’re using versus how much credit you have. For example, if you have a $1,000 balance on a credit card with a $10,000 limit, your credit utilization ratio is 10%. Low is good. But when you pay off your cards, your utilization isn’t just low: It’s zero. You don’t have a utilization ratio. This isn’t a big deal, but could cause a minor drop.
Then, there are the types of credit you have. Ideally, the credit score folks want to see that you have both:
- Revolving debt — that’s credit cards
- Installment debt — that’s things like car and home loans
Since you paid off your credit cards, you no longer have revolving debt. Your credit mix isn’t as robust.
Bottom line? It’s possible that paying off debts may cause a slight, temporary drop in your credit score. But I say, “Screw credit scores!” Over the long term, paying off debt is the best thing you can do for yourself. Know why? Because paying interest makes you poorer, and earning interest makes you richer. And you can take it from me, Lauren: Richer is better.
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I founded Money Talks News in 1991. I’m a CPA, and I’ve also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate.
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