I recently paid off my car loan and my FICO® Score dropped. Is that possible?
In short: yes, it is possible.
An automobile loan is a type of credit known as an installment loan (as are personal loans, student loans, mortgages). With an installment loan, there is a set amount of money you borrow that is repaid with interest through fixed monthly payments over a fixed time period. For example, you borrow $20,000 to purchase a car and pay $350 each month for the next 5 years, at which point the loan is paid off.
Creditors assess the risk of lending money through a variety of factors, one of them being the breadth of experience you have with various types of credit. For creditors, demonstrating you can actively and successfully manage multiple types of loans and lines of credit means you represent lower risk of default if they lend you additional money. This is supported by our analysis of the credit risk associated with millions of credit files, and that's why one of the five key score ingredients considered in a FICO Score is the individual's credit mix.
If you pay off your only active installment loan, it is considered a closed credit account. Having no active installment loans, or having only active installment loans with relatively little amounts paid off on those loans can result in a score drop. Our analysis of millions of credit files over extended time periods of FICO® Score developments, has found that individuals with no active installment loans represent higher risk of default than those who have installment loans actively being repaid. Also, if you have multiple active installment loans and you pay off the most paid down loan, that can also result in a score drop.
Okay, so a good credit mix can help your credit score. Does that mean you should start applying for all the types of credit lines you don't currently have? In short, no.
If you want to add a new type of credit account to your credit mix, be sure to balance the risk versus reward. Is it worth a potential short-term drop in your score to apply for a loan just to show creditors that you can successfully manage multiple types of credit payments successfully? With credit mix being a relatively small percentage of your credit score, the answer may be no.
Note, it is possible to score in the upper 700s and higher even without any demonstrated installment loan activity. In addition, FICO® Scores are dynamic and the score drop shouldn't be viewed as permanent. It can go up again overtime with continued demonstration of positive financial behaviors.
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