If you’re trying to get your financial life on track, you may assume that paying off your consumer debt will solve all your money problems. Not only does this free up money each month, but it also should build your credit, right? Not necessarily. Here’s why.
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I paid off all of my debt, and my score dropped — why?
If you paid off your debt in the hope that your credit score would flourish, you may be disappointed. To understand why, it’s important to be aware of the factors that make up your credit score.
Nothing affects your score more than paying all your bills on time. It’s true that the age of your credit accounts, whether you’ve recently applied for credit and what kinds of credit you have affect your score. But no other factor carries as much weight as paying on time.
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The second-most-important factor, credit utilization, is the reason your credit may drop a little after you pay off your debt. Having low credit utilization (30% or less) is good; having no credit utilization may be harmful to your score.
I don’t want my credit score to drop — what should I do?
Consider using a small amount of revolving credit regularly; you can pay the balance in full each month to avoid interest. Your credit score will reflect that you’re using a small percentage of your credit and benefit from that low utilization ratio.
But if your low credit score is more a product of past mistakes or present disorganization, you need to develop better habits. Here are a few things you need to do to restore your score:
Make all of your payments on time. Think you can coast now that your credit card debt is gone? Think again. Medical and utility bills can hurt your credit if you pay late or forget to pay and they get sent to collections. If you can’t remember to make payments, automate them. Just make sure you’re getting every bill paid on time every month.
Watch for credit report errors. Any attempt to build your credit will be fruitless if the data going into your scores is wrong.
You can get free credit report information two ways: Some personal finance websites, including NerdWallet, offer report information on demand, and once a year you’re entitled to a free report directly from each of the three credit bureaus.
The reports you can get annually from the credit bureaus can run to dozens of pages. To make sure they’re accurate, follow our guide to reading credit reports. If you see an error, dispute it. Someone else’s file mixed up with yours or identity theft could potentially — and unfairly — hurt your score, and the sooner you address that, the better.
Hold off on applying for more credit. Opening new credit lowers the average age of your credit accounts and involves a “hard inquiry,” which can result in a small, temporary drop in your score. Refrain from applying for new credit for now.
Practice patience. Sometimes the best thing you can do for your credit is wait. A combination of patience and good habits will help any credit score bounce back.
Should I worry about my credit score dropping?
If your credit score dropped by a negligible amount when you paid off your debt, you likely don’t need to worry. Here’s a secret: You don’t need a score of 850 to get the best terms on credit.
A score of 720 or above is in the “excellent” credit score range. If you drop from, say, an 810 to a 790 it shouldn’t hurt you when it comes to getting favorable credit terms.
This article was updated Nov. 4 2016.