For anyone new to personal finance and credit, credit scores can be incredibly confusing. On the surface, FICO credit scores seem like a fairly easy thing to understand. If you have an income and pay your bills, you should have a pretty good credit score. However, it doesn’t exactly work that way.
Instead, credit scores are calculations made based on the data available to credit bureaus. For example, the amount of credit you have in your name, the number of accounts you maintain, and any recent account activity are all factors in determining your credit score.
Credit scores are ultimately a number between 300-850 that help lenders determines your creditworthiness. If you have a high credit score (740+), financial institutions will view you as a lower credit risk and offer better credit terms. Having a lower credit score could result in lower account balances, higher interest rates, and worse overall credit terms.
How Are Credit Scores Calculated?
According to MyFICO.com, an individuals credit score is calculated as follows:
FICO Scores are calculated using many different pieces of credit data in your credit report. This data is grouped into five categories: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%) and credit mix (10%).
To make things even clearer, MyFICO.com also provides a nice graphical depiction of how credit scores are calculated:
What all of this means is that all of your credit activities play a role in your overall credit score. So, when you hear someone say that opening a credit card might hurt your credit score, they’re not entirely wrong, but also not entirely right. Instead, credit utilization and payment history are both much more important than the number of card account maintained.
Can Paying Off A Credit Card Hurt Your Credit Score?
With all of that boring stuff out of the way, it’s time for the question at hand. See, based on the above, it seems that paying off credit cards would have a positive impact on your credit score. From my experience, that’s been 100% accurate.
Over the years I’ve made purchases with my card, waited for my statement to close, and paid off the balance. In doing this, my credit score has continued to improve and was recently just above 800. Likewise, I’ve never missed a payment, I also have an auto loan, and I keep my utilization (balance / available credit) below 30%. However, I recently discovered that paying off a credit card early, before the statement closes, can actually be detrimental to your credit score.
Paying Off Credit Cards Early
Over the past several weeks of being stuck at home I’ve noticed a dramatic decrease in my credit card usage. As a result, my credit card balances have been extremely low. So, about a month ago I decided randomly to pay all of my card accounts down to $0. I wanted a fresh start.
I made the decision to pay off all of my accounts around the 10th of the month and my statements close on the 15th. When my statements closed, I only had minor outstanding balances on two credit cards. The rest of my cards all showed a $0 balance with no payment due.
Unfortunately, all of this ended up having a negative impact on my credit score. When I checked my FICO score though my Citi credit card account I discovered that my score actually dropped by 13 points! Furthermore, when I checked to see why my score dropped found the following note:
Essentially, because my credit card balances were all $0 when my statements closed, it ‘appears’ to the folks at FICO that I am not responsibly managing my credit.
Final Thoughts
Personally, I can’t for the life of me understand how this makes sense. I currently have 7 credit card accounts that I have been actively using for the past several years. Each month, I end up with a small balance on each of those cards that I pay off a few days later. Doing this results in a very high credit score. However, when I pay down all of my cards to $0 my credit score drops? Somehow not showing a balance hurts my credit score? It just doesn’t make sense.
If I’m a creditor and I see someone who has tens of thousands of dollars in credit limits available and no balance, I’d think that person had a great credit profile. To me, that demonstrates liquidity which is ultimately what credit worthiness is all about!
So, the short answer is… Yes, paying off a credit card balance could hurt your credit score. Likewise, not paying off a large balance before your statement closes could also hurt your score. Opening an account could hurt your credit score. Closing a credit card could hurt your credit score. In reality, FICO credit scores are a bit of a joke. I’ve never really taken credit scores all too seriously.
Bottom line, if you use your credit card like you would cash and pay the balance off in full each month, you’ll end up with a pretty great credit score. If you fixate on every point and try to understand exactly how your score is calculated, you’ll most likely go insane.
Featured image courtesy of MyFICO.com
