Have you ever paid off a debt only to find that it caused your credit rating to drop?
Paying off your debt is a good thing. But why could this lead to a drop in the credit rating? If you track your account monthly, it can be very frustrating to pay off your loan just to see your score drop 22 points.
Moreover, while FICO staff provide us with a lot of information about how they calculate credit ratings, the actual formula remains a trade secret. We’ll take a closer look at the reasons for the change in your rating.
8 reasons your FICO rating changes from month to month
1. Age of negative items on your credit report
Events such as bankruptcy, foreclosures, or late payments are examples of negative factors that affect your credit rating. These events remain on the credit file for several years. For example, a delay in payment remains in the archive for about seven years. However, as these events age, their impact on your credit rating diminishes. As a result, your score may go up.
2. Changes in circulating credit balances
Changes in the revolving credit balance can cause fluctuations in credit scores. For example, your credit card balance can change from month to month when you use the card.
The loan utilization rate is calculated by dividing the amount of your credit card debt by your credit limit. For example, suppose you have one credit card with a balance of $ 5,000 and a limit of $ 10,000. So, $ 5,000 divided by $ 10,000 gives 0.5, which means you will have 50% utilization.
FICO considers this ratio both for individual accounts and as a whole. The lower the utilization rate, the better. FICO’s Tom Quinn says it is best to aim for no more than 20-30%. Learn more from Tom in his interview on the DoughRoller podcast.
Again, keep in mind that these renewable balances can change from month to month. Therefore, your ratio changes too. If it goes over a threshold that FICO deems significant, your score could drop. If it falls and exceeds a threshold that FICO deems important, your score may increase.
3. Age of accounts in your credit history
As your credit history and accounts age, your rating may improve. FICO checks not only your oldest account, but also the average age of your accounts. Points can increase when accounts exceed the age threshold, which FICO considers significant.
4. Changes in the FICO formula
FICO changes its formula periodically. FICO is constantly trying to improve its formula to make it a more accurate indicator of credit risk. The same is true for non-FICO credit scoring formulas. As a result, multiple versions of the FICO formula are used concurrently. When a new version is applied to your file, it can change your rating.
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5. Applying for a new loan
Applying for a loan can lower your credit score. However, as a rule, requests are not a significant factor in the FICO® formula.
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6. Going through the scorecards
Another explanation for the change in credit rating is getting a new grade card. This is called a scorecard hopping, where the FICO places a consumer in a new scorecard. FICO doesn’t just dump all consumers in the same bowl and evaluate us all the same.
FICO provides very little information about its scorecards. One factor, however, concerns those with a history of bankruptcy. Scorecards enable FICO to assess the risks of consumers in a similar position.
A scorecard switchover occurs when the FICO moves a consumer from one scorecard to another. For example, if bankruptcy details are removed from a consumer’s credit card, they will be transferred from the bankruptcy scorecard to another scorecard. Interestingly, even if you switch to a better scorecard, your credit score may drop.
Why? Because now you are being compared to another group of consumers. You may have excelled compared to others who have filed for bankruptcy. However, after the transition to the scorecard, you found yourself in a completely different group of consumers. In the long term, the transition should help, but in the short term, it can reduce your bottom line.
7. Late payments
This is the most important causative factor for credit rating fluctuations. Even one 30-day late payment can significantly affect your credit score. Late payments remain in your case for up to seven years. Even if you’re doing it right, one late payment can negatively impact your credit score.
Connected: How late payments really affect your credit score
8. Why did my FICO rating drop after paying off my debt?
This may seem counterintuitive at first, but it is true that your credit rating can drop after you pay off certain debts in full.
The credit rating is calculated using a complex formula. Unfortunately, this sometimes has unexpected negative consequences, and the repayment of loans can sometimes lead to a change in this formula in the negative direction.
For example, if you paid off a single installment loan, it could negatively affect your account. This is due to the fact that lenders prefer someone who can handle a variety of debts, which is also known as a favorable loan portfolio.
Paying off your loan can also negatively affect your credit score. For example, if you paid in full with a credit card with a favorable utilization rate, you may only be left with a credit card with a less favorable utilization rate. As a result, this ratio increases overall.
You could also pay off an older source of debt, which will adversely affect the average age of your accounts. Lenders prefer that you can pay off your debts for a long time. As a result, canceling this account could negatively impact your account.
3 tips for keeping track of your credit score
1. Make sure to check your credit report
You can get your credit report for free at Annualcreditreport.com. You will receive your report from each of the three major credit bureaus for free once a year. Check for errors. Misinformation can unexpectedly reduce your score. This happens all the time.
2. Take advantage of free services to understand what helps or hinders your assessment
The second thing you can do is use services that provide what are called educational points. These scores are not calculated using the FICO formula, but using many other credit scoring formulas. These services do an excellent job of informing you about your credit score. You can see what makes your score worse and what helps your credit score so you can figure out what you need to improve.
I can recommend two services: Credit Karma and Experian. They are both free. You don’t need a credit card. I have used all of them and they are very easy to use.
3. Keep track of your FICO score.
If you are buying or refinancing a home, you can see your FICO Score. Just go to myFICO… It comes with some expense, but it is not particularly expensive. They have a credit monitoring service that you can keep using every month.
3 tips to improve your credit rating
Of course, this is more than just monitoring your credit rating. You will also want to make an active effort to improve your performance over time. Before we wrap up, we’ll go over the most important things you can do to improve your credit score over time.
1. Pay off debts on time
Timely payments are the biggest factor that affects your credit score. Paying bills on time leads to fluctuations in the credit ratings of most people. One missed payment can remain on your credit report for up to seven years.
We recommend that you schedule a consistent time to meet these commitments. Set aside the day that works for you each month and focus on meeting all your debt obligations. This will ensure that paying bills / debts becomes a habit, reducing the likelihood that you will ever miss a payment. It also simplifies the process because you can do everything at once.
Connected: How to get out of debt
2. Keep your loan utilization rate below 30%
It is calculated as a percentage of the credit limit you are using. Lenders want to see a low utilization rate – preferably below 30% of the available loan. Know the limits for each credit card and be mindful of the amount you are spending (check regularly). The higher the 30%, the more there will be a downward trend in your credit rating. It is important to maintain these spending limits over time.
3. Only use credit that you can afford
This may seem like an obvious factor, but it is no less important. You need to rethink your understanding of a loan as a payment that you will need to make in the near future. In other words, do not use a loan if you are unsure of your ability to repay it. The more sources of credit you take, the less likely you are to fulfill all these obligations. We do not recommend that anyone take more than three credit cards and it is imperative to alternate usage so that the utilization rate of each card is not affected. Of course (and most importantly) remember to pay off your credit card every month.
Connected: 11 Easy Ways To Improve Your Credit Score Today
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