5 credit scoring head-scratchers

Most of the times, scoring rules make sense. Then there are these

Speaking of Credit columnist Barry Paperno
Barry Paperno is a freelance writer and credit scoring expert with decades of consumer credit industry experience, serving as consumer affairs manager for FICO (formerly Fair Isaac Corp.) and consumer operations manager for Experian. He writes "Speaking of Credit," a weekly reader Q&A column about credit scoring and rebuilding credit, for CreditCards.com. His writings about credit scoring have appeared in The Huffington Post, MSN Money, CBS Money Watch and other consumer finance websites.

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Question Dear Speaking of Credit,
What makes your credit score drop when a loan has been paid off early? – Delores 


Dear Delores,
In the vast majority of credit-granting situations, the rules of credit scoring makes a lot of sense. If you have a history of living within your means and paying on time, you’ll have a good credit score and be able to obtain new credit when you need it.

Yet, there are some anomalies arising from credit scoring formulas. I call them “head scratchers.” They occur when the finely tuned credit risk calculations penalize consumers for activity what would otherwise be considered sensible.

Your question brings one of them up. Why would paying off a loan early cause a credit score to fall?  And it’s just one of my top five scoring head scratchers in which credit scoring doesn’t make common sense and can lead unexpectedly to lower scores:

  • Early loan payoff.
  • Closing credit cards.
  • Refinancing a mortgage.
  • Settling an old charged-off debt.
  • No longer using credit.

1. Early loan payoff
By paying off your loan early, you changed how it appears on your credit report, from open to closed. I suspect that left you with no other open loans. That created a common consequence: You created a “credit mix” problem for yourself.

Though only making up about 10 percent of your score, scoring calculations within the credit mix scoring category look for an assortment of credit. The formula rewards those who show they can pay off the two main types of consumer credit – revolving (cards) and installment (loans). To get the most points from this category, it’s best to have at least one open account of each type, as lower scores often follow closing the only loan or card, for whatever reason.

2. Closing credit cards
When you close a card, its credit limit is removed from the credit utilization (balance/limit percentage) calculations. The formulas reward those who use a small percentage of available credit. By reducing the amount of available credit – the denominator in the balance/limit equation – you change that key ratio. A higher proportion of available credit being used results in a lower score. The penalty kicks in no matter what.

A score drop due to higher utilization will occur immediately. That’s true even if you have a long history of nothing but accounts paid on time and $0-to-low card balances. But the reverse is true as well: As soon as you lower your utilization, by paying off bills or getting a new card, the penalty goes away.

3. Refinancing a mortgage
When you refinance a mortgage for a lower interest rate, you pay off one mortgage and open another. That saves you money, so it’s a financially smart move, right? Not to the “new credit” scoring category, which is worth 10 percent of the score. New credit looks bad to this part of the credit score formula.

Any time a new account is added to a credit report, expect the score to drop. Cooked into the formula is a judgment that any newly opened credit account – even if it’s just one mortgage replacing another -- tends to indicate higher future credit risk.

4. Settling an old charged-off debt
A charged-off card balance is one that has been written off as a loss by the card company following many months of nonpayment. It hurts a score badly at the time it occurs. Over the years, even if the debt remains unpaid, scores slowly recover. With good behavior, a credit score can rise to the low 700s even with an old charged-off debt gathering cobwebs in a dark corner. That’s a score good enough to qualify for a good credit card and a good mortgage.

But let’s say a consumer negotiates a debt settlement with the original lender, perhaps to satisfy a requirement in a mortgage application. That act changes the credit report from showing the account as a charge-off to showing a “settled for less than the full amount due.”

Both are derogatory notations in a credit report. Unfortunately for this consumer, the new settlement date then replaces the original charge-off date as the date used by the scoring formula to determine the recency of the derogatory item. Since this date is much more recent than the charge-off date it replaced, the score can be expected to drop substantially despite the debt having been resolved.

5. No longer using credit
Many older consumers are proud to have no debt. After a lifetime of hard work and on-time payments, they have paid off their mortgages, car loans and credit cards. They may figure that if they ever need credit, their pristine records and lack of debt should make them prime candidates. Not so. They’re often surprised to find they can’t qualify for any loans, because they have no credit scores any more.

The minimum FICO scoring criteria requires that a credit report contain at least:

  • One account opened six months ago or more, and
  • One account reported to the credit bureau within the past six months.

To restart the credit scoring machine, they will then have to reactivate an old closed card if one of their previous lenders will do so without checking a credit score. If not, their only option may be to open a secured card that will be reported to the credit bureau after about 30 days and, as long as some of their old credit remains on their credit reports, reactivate their scores.

Real head-scratchers, I know, but that’s how the credit scoring formulas work.

See related: What goes into a credit score? FICO's 5 factors

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Updated: 02-21-2019