Credit Card
If you find yourself in the enviable position of being able to pay off your credit card debt, you may wonder, “Does paying off my credit card hurt my credit?”
The short and sweet answer is that just paying off your credit cards to a zero balance is almost always a good idea. And that goes for either paying off a balance for good or paying off balances every month at the end of each billing cycle. The only way it could hurt your credit score is if you close the credit card account after paying it off.
Card issuers like it when you pay them back and paying off a balance shows that you can make sound financial decisions. You’re establishing a good credit history and starting to build a strong credit report. Not carrying a credit card balance on your credit card accounts also means you don’t accrue interest, so you can avoid interest charges. On top of that, you won’t have to worry about making late payments – or missing them altogether.
But credit scoring is complicated, and several factors play into your credit score. In this article, we’ll try to clarify the sometimes-confusing world of credit scores and give you some ideas about how to use credit cards in a way that may benefit your score.
Why did my credit score drop after paying off my credit cards?
Just imagine: the day has finally come that you’ve paid off a large credit card balance. A month or two later, you request a free credit score to see how much your score increased. Instead, you discover that your score took a hit. Your credit score isn’t as good as you expected. What happened?
When people face this situation, it’s usually because of something else they did to celebrate paying off the card, and that’s closing the account.
Both paying off the balance and closing the account can have different effects on your credit score. To understand why this happens, you have to understand a little bit about credit scores and credit history.
The most important factor in your credit score is your payment history, which is your record of making on-time payments, making at least the minimum payment each month, and avoiding missed payments.
The second most important part of your score is your credit-utilization ratio. Every time you open a new credit card, for example, you have more available credit. Credit bureaus track how much total available credit you have relative to how much you are using, and that’s your credit-utilization ratio. Lenders see someone as more of a risk if they have used too much of their available credit.
The lower your utilization rate, the better it is for your credit score. A 30% credit-utilization rate is a considered good, and 10% is considered very good. The utilization score includes your total credit limit from all credit cards and other debts, and the rate for each individual account.
The math behind paying off a card
When you pay off credit card balances, you are using less of your available credit, increasing your credit utilization ratio. This looks good on your credit file but closing the account after you’ve paid it off might hurt your score. Let’s take a closer look.
Let’s say Card A has a $1,000 balance on a $2,000 limit, while Card B has a $1,200 balance on a $2,000 credit limit. You have a total balance of $2,200 and a total credit limit of $4,000.
The ratio for Card A is 50% and the ratio for Card B is 60%. The overall credit-utilization rate is 55% (divide $2,200 by $4,000 then multiply the result by 100 to express it as a percentage.)
Now, pretend you come into some cash and pay off the $1,000 balance on Card A. Your credit utilization for this card is now 0%. That’s great! You still carry $1,200 on Card B so the credit utilization rate for that card stays the same at 60%.
Paying off Card A helps your credit score because your overall debt-to-credit ratio goes down to $1,200 of debt and $4,000 of available credit. This means that your card ratio is now 30%, which is good, and your credit score should improve.
But if you close Card A after paying it off, your overall debt-to-credit ratio will shoot up to 60%. This is because you lowered your overall credit limit and are still using 60% of the available credit on your only credit card, Card B.
So, you started with an overall ratio of 55%, dropped it to 30% when you paid off Card A, and then bumped it up to 60% when you closed Card A. You are left with a higher ratio than you started with, and your credit score will more-than-likely be lowered.
Other considerations
Lowering your available credit isn’t the only potential negative outcome to closing your account after you’ve paid it off. Closing an account that you have had for a long time could impact the credit history part of your score, too. This part of your score considers the total length of time you have had credit and the length of time for each account.
Nevertheless, there may still be good reasons to close a credit card once you have paid off the balance, like having to pay a high annual fee or having been the victim of identity theft.
If you must close a card, there are ways to minimize the negative effect of closing an account. The easiest way to do this is to ask for an increase in the credit limit on another account that you plan to keep open. You can also open a new credit card, which will increase your available credit. It’s true that the credit card company will conduct a “hard inquiry” into your credit score before approving you, and that may impact your credit score. But the damage from a hard inquiry goes away rather quickly, in months, while the benefit of the higher credit limit can last for years.
Is it better to pay off your credit card or keep a balance?
Contrary to popular belief, it’s always a good idea to pay off your credit card when you can. When you avoid carrying a balance on your account, you avoid paying interest.
And here’s a little tip: Because almost all credit cards have a grace period running from somewhere between the date you make a purchase and the time your payment is due, you could avoid paying interest charges if you pay your bill at the end of each billing cycle.
Paying off the monthly balance also establishes a good history of on-time payments and keeps your credit utilization score low.
Wise use of cards
Using credit cards the right way is a great way to make purchases. Understanding how their use impacts your credit score could help you on your way to building better habits and achieving your goals.
This article is for educational purposes only and is not intended to provide financial, tax or legal advice. You should consult a professional for specific advice. Best Egg is not responsible for the information contained in third-party sites cited or hyperlinked in this article. Best Egg is not responsible for, and does not provide or endorse third party products, services or other third-party content.