By JENNA LEE
At Credit Karma, we're often asked whether paying off a loan or closing a credit card will improve one's credit health. In fact, some people even ask when their score will go up after they've closed an account, assuming that there's no way doing so could be a bad thing. However, what many people don't realize is that maintaining debt can be good for your credit health if you manage it responsibly. Making timely payments proves that you're a reliable borrower and can increase your creditworthiness in the eyes of potential lenders.
While it's impossible to pinpoint exactly how many points your score may go up or down, let's explore how closing an account could impact your credit health.
Closing a Credit Card
Simply put, closing your cards definitely has the potential to hurt your credit health. Here's why:
- May increase your credit card utilization rate. Your credit card utilization rate is the ratio of your credit card debt to your total credit card limits. When you close a card, you reduce your overall available credit. Unless you also curtail your spending, this will increase your credit utilization rate, which could hurt your credit health. Many scoring models consider your utilization rate highly important, as it's a quick and easy way to gauge how you're managing your credit and whether you'll be able to pay off your debts in the future. In general, it's best to utilize between 1 and 20 percent of your total credit limit, as this shows lenders that you're using credit but aren't dependent on it.
- Could lower your average age of accounts. While closing a credit card won't impact your average age of accounts right away, as closed accounts remain on your report for seven to ten years, if you close a card that is significantly older than your other cards, it could lower your average age of accounts when it finally falls off your report. Additionally, some credit scoring models may use only the average age of open and active accounts as a factor, which is why we only use your open accounts when calculating your average age of credit history on Credit Karma. While your average age of accounts isn't typically the most important factor used to calculate your score, it does matter and can negatively impact your credit health if it falls.
However, like most things in life, closing a credit card isn't entirely negative--it also can have its advantages. For example, if your card has an extraordinarily high interest rate or miscellaneous fees, the money you save by closing it may be worth any negative effects on your credit health. Alternatively, if you have a shopping addiction or an unmanageable debt load, it could make sense to close some cards to minimize your temptation to spend and rein in your spending. Of course, all of these pros and cons can vary based on your particular situation, so it's important to consider any additional factors before making a final decision.
Paying Off a Loan
While paying down credit card debt lowers your utilization rate and can benefit your credit health, paying off an installment loan like a mortgage, auto loan or student loan works a little differently, as doing so closes the loan. As mentioned earlier, closed accounts will still appear on your credit report for seven to ten years, but some models may only look at open and active accounts rather than closed accounts. In addition, when your loan does fall off, it could shorten your credit history and reduce your types of credit accounts. Keeping all of these factors in mind, it may be more prudent to manage your account through the term of the loan to show lenders that you're able to maintain your accounts responsibly over a long period of time.
With that said, paying off loans also has some obvious benefits. Less debt results in a more flexible cash flow, meaning you'll have more money to contribute to your emergency fund, retirement accounts and/or other savings accounts. In addition, paying off loans can lower your debt to income ratio, a factor that has a significant impact on your ability to get credit.
If you've recently paid off a loan or closed an account, it's best to educate yourself on how your credit health may be impacted so that it doesn't come as a surprise. You can use Credit Karma to continually monitor your credit report to stay on top of significant changes and ensure your information remains error-free.
In the end, while paying off a loan or closing an account in good standing may not necessarily improve your credit health in the short term, you should feel proud about sticking it through and making good on your promise to pay that money back. By paying off your debt, you've shown that you're a reliable borrower, and potential lenders will see that positive payment history for years to come. Congratulations and good luck in the next chapter of your credit journey!
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