Over the years, I’ve had almost every kind of debt: credit cards, personal loans, auto loans, student loans, medical debt. And I’ve been able to pay it all off, too. It sounds obvious, but I can’t overstate how great it feels to get rid of debt. Though it requires sacrifices, the payoff—like more room in my budget—is worth every missed happy hour or postponed purchase.
But a few months ago, I paid off one of my last student loans and was surprised at what happened the next time I checked my credit score: It was down 20 points. I went from being happy about my accomplishment to wondering if I’d make a mistake.
Determined to understand what was going on with my credit, I started doing some research and learned that all debt is not created equally. It’s generally split into two buckets—revolving debt and installment debt—and one is considered better for your credit score than the other.
Revolving debt can do the most damage to your credit score because it’s a signal to lenders that you may be a riskier borrower, especially if you are nearing your credit limit.
That’s because people tend to rely on credit cards when they don’t have access to cash. And when you don’t have access to cash, lenders may worry you won’t be able to repay those debts—which can cause your score to go down. Conversely, “paying off credit card debt will almost always cause your score to go up,” says credit expert John Ulzheimer, formerly of FICO and Equifax.
Making progress in paying back installment debt improves your score, too—usually. “The rare scenario where paying off debt causes you to have a lower score is if you pay off all of your installment loans and you then have no loans with balances,” says Ulzheimer. “[Credit] scoring systems reward you for showing positive activity on installment debt, so having none means you'll likely forgo those positive points.”
Not quite. “When you’re paying off debt, you shouldn't give any consideration to the impact to your credit scores,” says Ulzheimer. The benefits of paying down any kind of debt—more money for saving, investing and enjoying life—far outweigh the short-term (and typically small) ding to your credit. In fact, mine has already started to rebound.
Besides, credit scores aren’t the only thing lenders look at when determining whether someone would make a good borrower. Another important factor is your debt-to-income ratio (the amount of debt you carry compared to your annual income). Even if paying off an installment loan causes a temporary decrease in your credit score, it’ll improve your debt-to-income ratio, making you look more attractive to future lenders.