Why Did My Credit Score Drop After Paying Off Student Loans?

Making that last debt payment can feel liberating. The balance finally hits zero, and a weight is lifted off your shoulders. While an incredible accomplishment, you may notice a drop in your credit score, leaving you to feel quite defeated. It’s normal to wonder, “Why has my credit score dropped after paying my student loan? Isn’t that a responsible thing to do?” It does sound a bit backwards, huh?

However, it makes more sense when you understand how your credit score is calculated. Here’s why your credit score might drop after paying off debt.

How Your Credit Score is Determined

Your FICO credit score is calculated using five different factors: payment history, amounts owed, length of credit history, credit mix, and new credit. Each factor is weighed differently when calculating your score.

Payment History (35%)

To evaluate how risky lending to you might be, lenders will look at how you’ve handled credit in the past. If you have a spotless record, you’ll likely do well in this category. If your credit history is checkered with late or missed payments, however, you may lose some points here.

Amounts Owed (30%)

Having outstanding balances doesn’t necessarily make you a risky borrower to lend to. However, using a high percentage of your total credit limit is an indicator that you may be overextending yourself financially.

For example, if you have a total of $20,000 of available credit, and you’re using $19,000 of that, you may appear to be struggling financially. On the other hand, if your total available credit was $50,000, owing $19,000 wouldn’t be so bad.

In a lender’s eyes, having a high outstanding balance in comparison to your total credit limit puts you at a higher risk of defaulting on any one of your loans. Thus, a high credit utilization ratio will impact your credit score.

(Note: “Amounts Owed” is often referred to as credit utilization.)

Length of Credit History (15%)

Generally speaking, the longer your credit accounts have been open, the better your score may look in this category. Simply put, a long history of effectively managing your credit shows lenders you’re capable of handling credit responsibly.

Credit Mix (10%)

FICO scores also take into account your credit mix, or the variety of credit accounts you have (ie. credit cards, student loans, mortgage loans, retail accounts, etc.). While you don’t need to have an account open in each category, having a mix of credit accounts shows lenders you’re able to manage multiple lines of credit responsibly.

If you do have a mix of credit accounts and manage them effectively, it can give your score a boost.

New Credit (10%)

Opening several new lines of credit in a short period of time can be an indicator that you’re struggling financially. Thus, opening too many new lines of credit can hurt your score.

Why Your Score Drops After Paying Off Debt

While paying off debt is certainly something to be proud of, it may not reflect positively when it comes to your credit score. Here’s why:

It Can Change Your Credit Utilization Ratio

Let’s say you have three credit cards, each with a $10,000 limit. They’re set up as follows:

Card A: $5,000 balance
Card B: $6,000 balance
Card C: $1,000 balance

As a result, you’d have a credit utilization ratio of 40% (12,000 total outstanding balance / 30,000 total credit limit).

Now, let’s say you decide to pay off and close Card C. Your new credit utilization ratio would be 55% (11,000 total outstanding balance / 20,000 total credit limit).

By closing Card C, the credit limit associated with it is no longer factored into your credit utilization ratio. Thus, the new ratio of your outstanding balance to your total credit limit actually ends up being higher than it was before.

In some cases, closing an account can lead to a higher credit utilization ratio, as it changes the amounts owed in comparison to the total credit limit. This, in turn, will negatively impact your score.

It Shortens the Length of Credit History

When you close a line of credit, the credit history associated with it goes out the window. In the case of revolving credit, such as a credit card, this happens when you close a card. With student loans, this happens when you pay off the balance.

A few months after you make that final payment on your student loans, it will no longer be an active line of credit. The credit history associated with it, whether positive or negative, will be removed. Depending on how long you’ve had the account open in comparison to your other lines of credit, it could shorten your credit history.

For example, let’s say these are the three lines of credit you currently have:

Student Loan A: Borrowed 15 years ago
Student Loan B: Borrowed 11 years ago
Credit Card: Opened 10 years ago

In this scenario, the average age of your accounts is 12 years (15 + 11 + 10 / 3). If you paid off Student Loan A, the average age of your accounts would decrease to 10.5 years (11 + 10 / 2). 

The credit history you had from Student Loan A gets wiped from your record, and your credit history is calculated based on the other lines of credit you have active.

It Could Change Your Credit Mix

If you have both revolving credit (like credit cards) and an installment loan (like a student loan), paying off your student loans will shift your credit mix. This could negatively impact your FICO score.

Student Loan Options for Bad Credit

If your credit score has dropped, you may need to look into how and where to get private student loans for bad credit. Rather than searching for lenders one-by-one, we recommend starting the process with an automated student loan search tool. After you complete the free Sparrow application, we’ll show you the rates and terms you’d qualify for with 17+ premier lenders.

Here is a list of the best student loan options for bad credit:

Will Biden’s Student Loan Forgiveness Impact Your Credit Score?

While President Biden’s student debt forgiveness will provide relief to millions of borrowers, it may wind up hurting your credit score temporarily for the reasons discussed above. And while the impact to your score pales in comparison to the relief provided, it’s important to understand why and how your score may drop so you know what to expect.

How Long It’ll Take for Your Score to Recover

If your credit score drops after paying off debt, don’t fret. While quite the bummer, it typically takes around 1-2 months for your score to bounce back (if everything else remains the same). 

In the meantime, consider other ways to increase your credit score. Continue to use other lines of credit responsibly, and check on your score periodically to see if it increases as expected.

Final Thoughts from the Nest

While frustrating to see your credit score drop after paying off your student loans, it’s normal. Continue to practice healthy financial habits, and your score should bounce back in no time.

If, after a few months, your score is still the same, consider examining your full credit report to check for errors that may be preventing your score from recovering.