Why has my credit score dropped after I paid off my loan ?
UAE bankers explain how you can plan for such a scenario when huge debts are paid off
If you’ve worked hard to maintain a good credit score, it can be upsetting to see it drop, especially if your score drops as soon as you fully pay off a loan, when logic dictates that it should rise.
“You see your credit score drop even after fulfilling your payment obligations on a loan or credit card debt because removing the debt often puts your credit mix or your credit utilisation ratio out of balance, or even reduces the length or age of your credit history,” said Parthiv Patnaik, a Dubai-based banker with nearly four decades of experience in the industry.
He also noted that it’s possible the drop in your credit score had nothing to do with closing your debt account or paying off your debts at all. “Maybe you accidentally made a late payment on a different account, or a new credit inquiry caused a slight drop in your score. An error on your credit reports may also harm your score. It’s important to regularly check your credit reports for inaccuracies.”
Keeping your oldest credit card open, for example, as long as it has no annual fee, can help keep your credit account age up, and as a result, your credit score as well.”
Parthiv Patnaik | Dubai-based banker
Here are some likely reasons why your credit score has dropped suddenly:
■ Reason #1: Your ‘credit utilisation ratio’ has likely risen up
The percentage of credit you use versus the total credit available to you, i.e. your credit utilisation ratio, would have likely gone up for your credit score to be impacted in any way. For instance:
Scenario #1: Let’s say you carry forward Dh3,000 in credit card debt across Dh10,000 total available credit. Your credit utilisation ratio is 30 per cent, which is the expert-recommended threshold. What you should know is that credit utilisation, or amounts owed, make up 30 per cent of your score.
“Only revolving lines of credit, like credit cards, factor into your credit score, while instalment loans, like personal loans, do not,” explained Jose Paul, an Abu Dhabi-based banking analyst. But how does paying off a credit card could impact your credit utilisation ratio.
Scenario #2: Imagine you have two credit cards with credit limits of Dh5,000 each. One card has a Dh4,000 balance, and the other has a Dh1,000 balance. In this case your credit utilisation rate is 50 per cent (Dh5,000 divided by Dh10,000).
If you pay off the Dh1,000 debt and close the card, your credit card debt to credit availability ratio would jump to 80 per cent (Dh4,000 divided by Dh5,000). So, even though you paid down some of your debt, this shift in credit utilisation could cause your score to drop.
One way, Paul suggested, to avoid this would be to pay off the Dh1,000 debt and keep the account open.
■ Reason #2: Your average credit account age has likely decreased “Since the average age or length of your credit history makes up 15 per cent of your credit score, closing one of your oldest accounts can bring down this average and hurt your score,” Patnaik added.
“This is another reason why you should keep accounts open when you can, even if you’re not using them and they have a zero balance.
“Keeping your oldest credit card open, for example, as long as it has no annual fee, can help keep your credit account age up, and as a result, your credit score.”
As credit scores also consider how many types of credit you have and provide more favourable scores to people with a good mix of credit accounts. Paul said “If you close an account that changes your credit mix, it could hurt your score. For example, if you only have credit cards and a personal loan and pay off your personal loan, you’re down to a single type of credit.
Bottom line
Patnaik and Paul both reaffirmed that any potential drop in credit score doesn’t mean you should ignore what you owe.
The benefits of paying your debts are far greater than the drop that you may see in your credit scores, and the negative impact is likely to be temporary.