Why your credit score dropped after paying off a car loan?

You finally paid your car loan off and expected to see your credit scores increase. But surprise, after being financially responsible and reducing debt, your score drops.

It can make you feel like “I’m working hard to improve my credit, but the system seems to be working against me.” But hold on, it’s just a temporary dip.

Why your credit score dropped after paying off car loan

Car loans are considered installment loans, like personal loans, mortgage and student loans. The credit scoring model rewards credit histories with active installment loans because it adds to the mix of credit types you’re currently managing. Credit mix accounts for ten percent of your overall credit score.

But what happens if you pay off your only active installment loan? It becomes a closed credit account. Without an active installment loan, or with only one of your installment loans paid off, your credit score could drop.

What is mix of credit types?

Credit mix accounts for ten percent of your overall credit score. One of the ways lenders assess risk of default is by reviewing your experience with different types of credit.

If you’ve successfully managed multiple loans and credit lines, you’re seen as a lower risk. The mix of credit types can include personal loans, mortgages, and student loans.

FICO says that studies have found that individuals with no active installment loans represent higher risk of default than those who have installment loans actively being repaid.

This insight is based on analysis of millions of credit files and is a key component in calculating a FICO Score. But that doesn’t mean you should rush to apply for all types of credit lines you currently don’t have to improve your credit mix. Paying off debt is the right step towards financial freedom.

It’s only a temporary drop

Any credit score drop is temporary. Since credit scores are dynamic, it can rise again with continued positive financial behaviors. It’s very doable to score in the upper 700s without any installment loan activity.

How to increase credit score after car payoff?

Focus on fundamentals to restore your credit score, including:

• Pay all bills on time: Payment history is the biggest credit score factor.
• Keep revolving credit balances low: Aim for a utilization rate below 10%. Lowering the amounts owed is one of the easiest credit hacks to increase scores.
• Avoid new credit inquiries: Apply for new credit only when necessary.
• Time: Scores naturally recover as you demonstrate responsible credit habits.

Final thoughts

Credit score drops due to paying off debt are usually minor and temporary. The positive effects of paying off debt far outweigh any minor score fluctuations. 

You’ve lowered your debt-to-income ratio, and saved interest charges! Now, that money can be invested or put into a high-yield savings account to earn you money.