Getting out of debt is a good thing, so why do some consumers see their credit scores decline after paying it off? There’s a common misconception that you must be in debt to have good credit, but that’s not the case. You do, however, have to use credit to earn a good credit score, and it’s sometimes difficult to see the difference.
Credit cards are probably the best example of this: If you pay your credit card bill every month, you are not in debt, and you’re building credit by using the card.
Swear Off Debt, Not Credit
If you’ve just paid off your credit cards, you maybe said to yourself, “I’m never falling into debt again.” That’s a great goal, but if your plan involves cutting up the cards and never using them again (and you have no other debt, such as a mortgage or student loan), you may find yourself without a credit score.
It’s different among credit scoring models, but you have to have some recent credit activity on your credit report in order to have a credit score. If you don’t use your credit cards after paying the outstanding balances, the issuer will likely close the card due to inactivity, meaning they won’t report to the credit bureaus anymore. If that was your only form of recent, active credit, you’ll lose your credit score.
You can avoid this by using your credit card sparingly and paying the bill immediately. If you didn’t have a credit card before emerging from debt, you can get a secured card and apply the same strategy. Consider asking a trustworthy friend or relative to add you as an authorized user on one of their credit cards. That’s not a choice to be taken lightly by either party, so do your homework before trying it.
Prepare for Some Changes
Continuing with the credit card card example: Paying off credit card debt can lead to a variety of shifts in your credit score. If you were using a high percentage of your credit limit, your credit score may improve, because you will have reduced the ratio of your debt to your available credit. On the other hand, if you stop using the card, the issuer may close it, which would reduce your available credit and hurt your credit utilization rate.
Your mix of accounts also contributes to your credit score. Say you had student loans and credit cards, and you’ve just paid off your last student loan. If you don’t have an active installment loan on your credit report, your credit score may go down, but this isn’t nearly as important to your credit score as making payments on time or keeping your credit utilization rate low.
It’s easy to see how your various credit accounts impact your credit standing if you know how scores work. You can get a free, monthly snapshot of your credit and credit scores with a Credit.com account. Having a good understanding of your credit should allow you to reach your goals of getting out of debt without hurting your credit in the process.
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