One of the best feelings in the world is paying off all your debts. What’s funny is how our credit score changes in ways we least expect it to after we settle our debts.
The way you clear your debt depends on how you pay it off, and it may not immediately reflect on your credit score. If you’ve settled it by making on-time payments and finished before or by the term ends, you’re bound to see good results. In some cases, settled debts might even negatively affect your score.
Foremost, it is prudent to keep in mind that credit card accounts are advised to be kept open after paying them in full.
Your credit utilization rate, or credit utilization ratio, is a factor in computing credit scores. This is calculated by dividing your credit card balance by your credit limit. Multiplying the result will yield your credit utilization ratio. This ratio is best kept as low as possible, around 30% or lower is a good margin to aim for.
With that, you can see how closing that credit card account can result in lower credit scores. That’s because you’ve decreased the total credit limit, possibly ruining your credit utilization ratio. Keeping that account open will ensure your total credit limit stays the same.
For example, you have two cards, a $1000 credit limit on each one, and a credit balance of $500 each. $1000 divided by $2000 will yield .5, multiplied by 100 will give you 50%.
Let’s say you fully pay for one card, closing the account right after. Now, you’ll have a $1000 limit with a $500 balance. In theory, you owe less. Unfortunately, your credit score will still show a utilization rate of 50%.
It is also important to remember that debts are classified differently. For example, a loan would be seen as an installment account. Paying these off often yields in a sudden, temporary drop in score.
These dips shouldn’t really cause you to panic. Some people take this the wrong way and try to boost their score by keeping installment accounts open. This not only causes you unnecessary stress, but it also does nothing for your credit score in the long run.
At the end of the day, the goal is to stay on top of your financial liabilities. Understanding the way credit, loans, and credit scores is only the beginning. You can learn more about the industry at Any Credit today to get started on that journey.