In the minds of most borrowers, paying off a loan should exhibit financial responsibility. But, many borrowers who do so will see a drop in their credit scores. There is an explanation for that, and it has to do with how credit scores are calculated.

John Loo / Flickr |

John Loo / Flickr source


– Donald P.

A: Experiencing a drop in your credit score is actually a very common occurrence when an installment loan (e.g., mortgage, auto loan and student loan) is paid off. Luckily, in the long-term, there should be no major impact to your creditworthiness.


Firstly, there is the debt utilization ratio, which is calculated by dividing your total debt by your combined credit limits. When an installment loan is paid off, the account is marked as closed on credit reports and the credit limit on that account is no longer recognized. This effectively removes a portion of your combined credit limit.

For example, you had a $1,000 balance on a credit card with a $5,000 credit limit and a $1,000 balance on a student loan with an original amount of $20,000 (which is noted as the credit limit of the account). You had a 4% debt utilization ratio.



And, the average age of accounts is used to determine your credit scores — the older the accounts, the better your credit scores will be. Although an account is closed, the age of the account is used to calculate the average age of accounts. However, the closed account stops aging, so it can actually bring down the average age of your accounts.





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