Paying off a credit card can increase your credit score, but that isn’t always the case.Image source: Getty Images.
You may have heard that paying off a credit card balance in its entirety is a great way to boost your credit score. And for the most part, it’s true. If you pay off, or even make a substantial reduction in your credit card debt, you’re likely to see your credit score rise.
Having said that, like most financial topics, it’s not quite as easy as that. The magnitude of a payoff-induced credit score increase can vary dramatically depending on your circumstances, and in some cases, paying off a credit card can even make your score go down.
With that in mind, here’s a quick guide that illustrates how paying off a credit card could affect your credit score, and some of the variables that might apply to your particular case.
How your FICO® Score works
Before we dive into the finer points of how paying off a credit card could affect your credit score, it’s important to have a basic knowledge of how your credit score works. And, the FICO® Score is by far the most popular scoring model used by lenders, so let’s take a closer look.
The FICO credit scoring formula is a closely guarded secret, but we do have some knowledge of how it works. Your score is made up of information from your credit report, which is broken down into five weighted categories:
- Payment history (35%): Not surprisingly, the most important FICO factor is paying your bills in a timely manner. If you pay your bills on time, it will help this category, while things like late payments, charge-offs, and collection accounts hurt you.
- Amounts you owe (30%): Your debts are the second most important factor in your FICO® Score. It’s important to note that this category doesn’t put much consideration on the dollar amounts of your debts, but focuses on the amounts you owe on your credit cards and revolving accounts relative to your credit limits, and the amounts you owe on your loans relative to their original balances.
- Length of your credit history (15%): This refers to the age of your oldest reported account, the average ages of all of your reported credit accounts, and other time-related factors. Generally speaking, the longer-established your credit history is, the better your score will be, all other factors being equal.
- New credit (10%): You may have correctly heard that the credit accounts you’ve recently opened, as well as the times you’re applied for credit, can drag down your credit score, and it’s because of this category.
- Credit mix (10%): This refers to the diversity (or lack thereof) among your credit accounts. Do you have both revolving and installment debts, or just one type? Do you have several different categories of credit accounts, such as a mortgage, auto loan, student loan, credit card, etc.? The idea is that creditors want to see that you can be responsible with all types of credit, not just one or two.
How paying off a credit card affects your score
Here’s the short answer: Paying off a credit card is generally a positive factor when it comes to your credit score. The reason is that the "amounts you owe" category is the second most important factor in your FICO® Score, and that lower balances relative to your credit limits can have a major positive impact.
In other words, if you owe $2,000 on a credit card with a $2,500 limit, you’re using 80% of your available credit, which indicates to lenders that you might be over-extending yourself. On the other hand, if you pay it off and you’re using 0% of that credit line, it indicates responsible debt management as well as financial flexibility.
Additionally, of the two major types of debt -- revolving (credit cards and credit lines) and installment (loans) -- revolving debt is the one that can really drag down your credit score if it’s overused. By paying off your credit card, you’re essentially taking a bad debt out of the FICO calculation.
Other things to consider
So as a general rule, paying off a credit card balance should make your credit score go up. However, there’s no way to know exactly how much it will help, and in certain cases, paying off a credit card could even make your credit score go down.
There are several other factors that come into play, which can determine just how much of an impact paying off a credit card can have:
- Your other credit accounts play a major role here. For example, if the credit card you paid off was your only credit card, the impact could be much larger than if you still have several other credit cards with balances.
- The amount of credit card debt you paid off, relative to your available credit, also can be a major determining factor. Obviously, if your credit card was maxed out or close to it when you paid it off, you could see a major upward movement in your FICO® Score. On the other hand, if your balance was extremely small -- say 5% of your total available credit or less -- and you don’t have any other credit cards with balances, there have actually been reports of scores declining upon payoff, especially if the cardholder had near-perfect credit.
- Also, if you pay off your credit card and then close the account, it can be a negative catalyst to your credit score. Think about it this way -- if you pay your credit card off and leave it open, you have an untapped credit line that helps the "amounts you owe" category. On the other hand, if you close the account, you lose this positive factor.
Every situation is different
The bottom line is that there is far too much information considered by the FICO credit scoring formula (as well as most other scoring models) to say something like, "…if you pay off your credit card, your score will increase by XX points."
If you pay off a credit card that had a significant balance, and the paid-off amount represented a large portion of your outstanding credit card debt, you can generally expect a pretty significant boost to your score. Conversely, if you pay off a credit card but didn’t have much of a balance in the first place, or if you pay off a credit card and then close the account, you’re unlikely to see a massive rise in your score. And if your situation is somewhere in between, you’ll just have to go ahead and pay it off to find out for sure.
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