I read an article this morning about a woman who was irate because she paid off a loan and her credit score went down 30 points. I don’t blame her. I’d be angry as well. You should be rewarded for good financial habits, not penalized.
I also understand why this happened and if you read my recent post on credit scores, you’ll understand as well.
Credit Score Factors?
Here are the 3 most impactful factors in determining your credit score:
- Paying on time
- Amount owed compared to available credit (don’t max out)
- Length of credit
Length of Credit Matters
#3 is likely the one that caused the pain here. My guess is that the loan that was paid off was one that had been active for a long period of time. Her other credit sources were probably much shorter duration.
Example
Let’s look at a hypothetical example. If I have a personal loan that has been active for 10 years, and my only other source of credit is a credit card that I opened last year, my length of credit looks pretty good. I have been making payments for 10 years. Assuming I’m paying on time and I’m not maxing out my card, my score could look pretty good.
Let’s say I then pay off the loan. This loan drops off of the active credit items on my report so my length of active credit drops from 10 years to < 1 year. Some lenders will now see me as a higher risk because I have a much shorter length of time in which I’ve been making regular payments.
Active v. Dormant Credit
I emphasize active credit items here because I couldn’t find a lot of info on how FICO and others handle active history v. dormant (paid off) history. The credit report that they use to calculate the score has history on both but it is unclear how each of the different scoring agencies like FICO use that info in their calculations. That’s their special sauce so I’m not surprised.
Wrap-up
So, I read the article and it made me think of the recent posts on credit score. I think it supports what we talked about but also provides a real life example of where the score doesn’t behave as we would hope.
I’m trying out short articles to tie back to a prior post, rather than going back and updating the original with new info. There are pros and cons with both approaches. Let me know what you think.