I thought paying for my car would help my credit score. I was wrong.
Years ago, when I found out I had twins, I was thrown into a huge financial loop. Having multiples meant having to buy loads of baby gear since we only had one set to pass on from our older child. It also meant that we wouldn’t be able to fit our kids into our old car as my son was just a toddler when the twins were born and we needed a vehicle that could accommodate three seats in the car. ‘auto.
As such, we did what every hip parent does – we bought a van. But since we couldn’t pay for one directly (minivans, while obviously not cool, are surprisingly expensive), we decided to finance it with a multi-year auto loan.
For several years, our car payments took a big chunk of our budget, so I was thrilled when we finally made our last payment. But when I checked my credit score after paying off my car loan, I saw something surprising: my score had gone down.
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Why paying off a loan can hurt your credit rating
You would think that from a credit score standpoint, you would be rewarded for paying off your debts. After all, one less loan means less financial obligation. Moreover, all loans are designed in such a way that you are supposed to be free from them eventually. No one signs a life mortgage, for example. Instead, homebuyers will typically sign a 15, 20, or 30 year loan and be done paying it off within that time frame.
This is exactly what happened to me with my car loan. After years of payments, I ran out of money on my car.
So why has my credit rating dropped? Well, there are several possible reasons.
Average age of accounts
First of all, the average age of your different accounts goes into the calculation of your score. This is why it is always wise to hold onto credit cards that you have had for a long time, even if you rarely use them. In my case, this auto loan was in my credit history for several years, so when it went away it may have reduced the average age of my open accounts, lowering my score a notch.
Another thing is that aside from my mortgage, after my car loan was paid off, my only remaining accounts were credit cards – and I have quite a few. A separate factor that goes into calculating a credit score is your credit mix. And you will generally be rewarded for having a good balance on credit cards and installment loans – that is, loans that you pay off in equal amounts over time. By getting rid of my auto loan, I may have shifted my credit mix into less favorable territory, which could also explain why my score has dropped.
To be clear, my credit rating only dropped about 15 points when my auto loan was gone, so it wasn’t a catastrophic drop. But if you’ve been planning on paying off a loan you’ve had for a long time, you might want to prepare for a temporary blow to your credit score – despite the fact that you’ve acted responsibly in paying off the debt. like you were supposed to.