While getting out of debt is no doubt a good thing, many consumers are surprised to see their credit scores fall after finally paying off their debt. That’s led to a bit of a misconception about needing debt in order to have “good” credit but, while using credit is a good way to increase your credit score, there are certainly good and bad ways to do it.
For example, if you use credit cards and pay them off in full every month you won’t have debt and you’ll also be building good credit. The lesson? Avoid debt but don’t avoid credit cards.
Many people fall into the trap of paying off their credit cards and then promising themselves that they’ll “never go into debt again.” While staying out of debt is definitely an excellent plan, cutting up your credit cards and never using them again isn’t, and could leave you with either a low or no credit score.
While there are different credit scoring models and the way they figure out your score isn’t always the same, in order to have a credit score you need to have had at least some recent activity on your credit report. Not using your credit card after you pay off the outstanding balance will likely cause the card issuer to close your account due to inactivity and, once that’s done, they won’t report anything to the major credit bureaus. If that card happened to be your only type of active credit, you will lose your credit score altogether.
The easiest way to work around this is to use your credit card occasionally and, when the bill comes due, paid it off in full immediately. If you’ve just emerged from heavy debt and didn’t have a credit card, getting a secured card and using the same strategy is an excellent idea.
The fact is that, depending on what type of debt you have and what you did to pay it off, paying off your credit card debt in full can cause a number of different shifts in your credit score. If, for example, a high percentage of your credit limit was being used before, your credit score might actually improve because your “debt to credit ratio” will be lowered.
If you stop using the card completely however, as we mentioned above, the card issuer may close your account. What this does is reduce the available credit that you have, something that could hurt your “credit utilization ratio” and lower your credit score.
The type of accounts that you are using at the same time, or the “mix” of credit that you have, can also affect your credit score. If, for example, you had credit card debt and student loan debt and you’ve recently paid off your student loans, your credit score may go down because you don’t have any active installment loans on your credit report. On the other hand, paying your credit bills on time and keeping your credit utilization rate as low as possible is much more important to your credit score.
Having an understanding of how your various credit accounts affect your credit standing, as well as how credit scores work, is always a good idea. If your goal is to get out of debt without hurting your credit score, use the advice above and do your own research as well so that you’ll not only be debt-free but also keep your credit rating healthy.