You’ve finally done it. After months (maybe even years) of chipping away at your debt, you’ve finally paid it off. You sit back, relax, and wait for your credit report to reflect this major accomplishment…only to see that your score hasn’t changed at all; it may have even decreased. You’re probably confused and frustrated—isn’t getting out of debt supposed to raise your score?
The long-term answer is yes! However, in the short term, the many factors that make up your credit score can cause some unexpected results in the immediate aftermath of your victory over debt. Read on to see how a variety of factors can account for your fluctuating score.
What Kind of Debt Payoff Method Did You Use?
Different methods of paying off debt can have different effects on your score.
Debt Settlement
While debt settlement is an excellent solution that helps many individuals in financial hardship pay off debt for less and faster than other methods, it typically has an initial negative impact on a person’s credit score. If your score was strong before beginning the debt settlement process, then you’re likely to see your score drop and then increase again over time. High credit scores reflect accounts that are paid on time in adherence to the original credit agreement, so when that agreement is modified or negated during debt negotiations your credit score will reflect this with a temporary decrease.
Credit Counseling
Because credit counseling is tailored towards a person’s specific financial needs, there’s no universal effect to be expected for every case. However, if a credit counselor has you close your credit cards, that will likely cause your score to drop. This occurs because closing accounts lowers your available credit, which in turn impacts your credit utilization ratio. This ratio is calculated not only across all of your cards but also for each individual card. Closing accounts increases your overall utilization ratio by reducing the total amount of credit you have available while leaving your total usage the same, which in turn causes your credit score to decrease.
Additionally, the payment status of the accounts included in the credit counseling program has an effect on your score. If an account is reported as settled, which means you didn’t pay what was originally agreed upon, then it will likely reflect negatively on your score. Failure to make your monthly payments while going through credit counseling can also cause your score to suffer.
Debt Consolidation
While debt consolidation is primarily used as a way to lower or eliminate a large amount of debt, it can also have a positive impact on your credit score. Consolidating your revolving debt (such as credit card balances) also reduces your utilization ratio and therefore increases your credit score. If the balances on those accounts are kept low, your score will receive a boost over time.
Cash-Out Refinancing
A cash-out refinance allows you to replace your existing mortgage with a new home loan that’s for more than what you currently owe. The difference between your old loan versus your new loan provides you with the additional funds needed to consolidate and pay off your higher-interest debt. There are multiple ways, both positive and negative, that this debt solution can impact your credit score.
Cash-out refinancing can help boost your credit by reducing your credit utilization ratio on the other balances you pay down. However, if your new mortgage amount and monthly payment are higher, your credit utilization ratio then increases. Additionally, by replacing your previous mortgage, you lose the credit history benefit of all payments made over time which positively influenced your score.
Bankruptcy
Filing bankruptcy can have a severe negative impact on your score, and will remain on your credit report for seven years for a Chapter 13 bankruptcy and ten years for a Chapter 7 bankruptcy.
What Other Factors Could Be Impacting Your Credit Score?
Credit Mix
If you paid off an installment loan but still have credit card debt, your score is likely to decrease. Lenders like to see what’s known as a credit mix: a mixture of installment loans, investments, revolving credit, etc. in your credit portfolio. Because installment loans have a set timeframe for when they will be paid off, they don’t impact your score as much as revolving debt, which varies from month to month. If you pay off your car loan but still have credit card debt, your credit mix isn’t as balanced as it once was because it is now made up of more revolving debt than installment loans.
Standing of the Loan
Whether or not the account you paid off was in good standing also impacts your credit score. If you never missed a payment on your loan, always paid on time, and paid off the loan in full, your account is considered to be in good standing. This reflects positively in your credit score.
On the other hand, if you missed payments before paying off the loan or didn’t pay off the loan in full, then those previous missed payments can keep hurting your score even after the account is closed.
Regardless of Your Score, Paying Off Debt Is Always Good!
Regardless of whether your credit score increases, decreases, or stagnates in the short term, paying off a loan is a massive accomplishment! Celebrate and reflect on how far you can go now that you have one less debt to pay off. That extra money can kickstart your progress in achieving another one of your financial goals. While it may be frustrating to not see improvement in your score right away, be patient—your score will reflect your hard work soon enough!
If you’re in the middle of paying off debt and could use some extra financial guidance, let us help! At ACCS, our team of debt specialists are always here to assist and answer your questions. Looking to start your journey towards becoming debt-free? Request a Custom Debt Relief Plan today to learn more about your available options.