Q. I recently paid off my car loan. Can you please explain why my credit score dropped?
A. Credit scores work in mysterious ways.
Paying off a debt might seem like a good way to improve your credit, but paying off an installment loan like a car loan can actually ding your score because it raises your utilization ratio, said Brian Power, a certified financial planner with Gateway Advisory, LLC in Westfield.
“Your utilization ratio tells potential lenders how much debt you owe and how much of your total available credit you are using,” Power said. “The lower your utilization ratio, the better it looks to lenders — and the higher your credit score will be — because it’s more likely that you’ll be able to make your payments.”
He said about 30 percent of your credit score is calculated using the utilization ratio.
When it comes to credit scores, there’s a big difference between revolving accounts such as credit cards and installment loan accounts such as a mortgage or car loan.
Power said an installment loan is a loan with a set number of scheduled payments spread over a pre-defined period of time. When you pay off an installment loan, you’ve essentially fulfilled your part of the loan obligation — the balance is brought to $0 and the account is closed.
“By the account being closed, your total available credit portion of the utilization ratio decreases,” he said. “So paying an installment loan off early won’t earn you any additional credit score points, and keeping them open for the life of the loan may actually be a better strategy for your credit score.”
Credit cards, on the other hand, are revolving accounts, which means you can revolve a balance from month to month as part of the terms of the agreement, Power said. And even if you pay off the balance, the account stays open. A credit card with a zero balance — or a very low balance — and a high credit limit is very good for your utilization ratio.
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