In December 2020, I finally paid my car off after six (!) years. This was a personal finance victory I had long anticipated. It meant I would now have an extra $230 a month to spend.
But I was dismayed to learn that it also meant a dip in my credit. I don't always check my credit score, but I was curious to see what impact paying off my loan would have. Well, dear reader, it meant a 30-point dip in my Transunion and Equifax credit scores, according to Credit Karma.
Rather than wallow in my rage, I decided to find out why this had happened to me.
How credit scores are calculated
Credit scores are based on your credit report. A credit report is a comprehensive history of how much and how often you borrow or pay down credit cards or loans. Any time you make a change to your credit history — eg. getting a mortgage or paying your credit card bill — that change gets fed into a proprietary algorithm, which spits out your three-digit credit score.
Because we can't see inside these algorithms, the way they respond to certain changes can be unpredictable. A major change to your credit, like, say, paying off a long-running auto loan, can create an instability in your score, said Rod Griffin, senior director of consumer education and advocacy at Experian, a competitor to Credit Karma.
This change shouldn't be permanent, Griffin said.
"What we typically see is it's not usually huge and it's usually short-lived, so if you give it a payment cycle or two, it bounces back to what it was," he said.
Credit Karma wouldn't talk to me on the phone, but their spokesperson sent me two reasons why my score might have dipped:
A change to my credit mix: Having a variety of credit, including credit cards, mortgages and auto loans, is generally good for your credit score. Removing a loan your portfolio of credit can have a negative impact.
Shortening the length of my credit history: That auto loan was one of my oldest credit accounts. Closing it could have shortened the overall age of my accounts, leading to a drop in my score.
Here’s our explainer on building credit and what makes it change.
How to handle big changes in credit
Before paying off an auto loan or making some other big change to your credit, keep an eye on your credit report and credit score, Griffin said.
"Make sure your score is in good shape," he said. That way, any dip will have less impact.
Here’s our breakdown of how to get a high credit score.
Credit scores range from 300 to 850 — the higher the better. My credit score before paying off my car was 790 according to Transunion and 799 according to Equifax, so I still had excellent credit despite the 30-point drop.
“In that case the impact is really nonexistent,” Griffin said. “It won’t change your ability to qualify for credit.”
How can you maintain a solid score? The most important factors are:
Keep making all your payments on time. This is the biggest part of a good score.
Keep the amount of credit you use low relative to the amount you have available. This is known as your credit utilization ratio, and the lower it is, the better.
Avoid opening new accounts unless you need them.
And just in case, space out any major credit moves. If you do pay off a loan, consider waiting a month or two before applying for new debt to allow your score to stabilize.
Above all, celebrate the win. Paying off my auto loan may have led to a dip in credit, but I can fit a few more takeout dinners into my budget every month, which is basically my most important financial goal.
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Image: GettyImages / Arslan Ozgur Sukan