Credit scoring quirks that make you wonder

This post originally appeared July 21, 2016 on CreditCards.com as “5 Credit scoring head-scratchers

By Barry Paperno

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.

6 thoughts on “Credit scoring quirks that make you wonder

  1. CaliSteve

    Hi,
    I have a friend who plans on paying a couple of charge-offs that are still owned by the original creditor and is reporting monthly to all three CRAs. He is planning to pay them off in full this month and I was wondering if he will see a bump in his credit score.

    Reply
  2. Barry Paperno Post author

    Hi CaliSteve!

    North or South Cali? (I’ll hold off on saying which one I prefer, though I know and love both very much. :-))

    Whether or not your friend sees a score bump after paying those charge-offs depends largely on how recently they became charge-offs. If recently, say within the past year or so, then yes, a score increase is likely, though the items will remain on your credit report and continue to suppress your score for about seven years from the charge-off date.

    Specifically, that score bump will be the result of the removal of the past-due balances from your credit report. When a charge-off has occurred recently the dollar amount hurts your score in addition to the bad debt status, such that the higher the balance the lower the score. But once old enough, the balance no longer affects the score.

    As charge-offs age, their recency continues to be a big score driver, with the older they get the less negative impact they have on your score. Once paid there will be nothing you can do about this ‘recency’ factor other than let the passage of time do it’s thing. And, of course, by paying them off at any time during that seven years, you’ll avoid future collections and judgments that could extend the score damage for many more years.

    -Barry

    Reply
  3. CaliSteve

    Hi Barry-
    In Nor Cal.

    I believe both charge off accounts were charged off in 2011 or 2012, however they are still owned by the original creditor and reporting monthly to all three CRA. Ive been told when they report monthly it suppresses your score. Paying them would stop the “bleeding.”

    Reply
    1. Barry Paperno Post author

      Moved away from my beloved Nor Cal 3 years ago after 40+ years there…

      Interesting that the creditor continues to report those C/Os. Typically they stop reporting once reaching C/O, foreclosure, repo, or other write-off situation. However, it’s a clever move on their part, as this way they can encourage your friend to pay to ‘stop the bleeding’.

      My earlier statement about dollar amounts only counting when they’ve occurred recently was based on the assumption that the C/Os had stopped reporting. The ‘recency’ determination for those calculations is based on the last reporting date, which, for your friend, has occurred much more recently than if reporting had stopped upon reaching C/O.

      Since they’ve continued to report, there’s a sort of good and bad news scenario:
      * Good – paying them off is likely to help the score after all.
      * Bad – since they continued to be reported after the C/O date, the score has been lower all this time than if had they stopped reporting earlier on, since after a year or so the balances would have stopped contributing negatively in addition to the C/O status, dated back in 2011-12.

      I realize this must sound a bit off the wall and hope it makes some sense. Bottom line, since the C/Os have continued to be reported for the last 5 years or so, paying them off now should help your friend’s score, though by how much is anyone’s guess after all these years. Let me know if any of this needs clarifying.

      -Barry

      Reply
  4. Greg Smittle

    I am not sure what charge off means but in my situation, I had 8k in debt and recently paid off all my debt and now have 0 debt. My FICO score went from 697 to 667 in less than a week. If I don’t use the cards again, will my credit score go back up?

    Reply
    1. Barry Paperno Post author

      A charge-off means that a debt went delinquent — unpaid — for so long that the creditor eventually wrote it off as a loss.

      Since you now have $0 debt, it would be best for your score to continue using at least one card to charge small amounts while paying in full each month. With that, the passage of time, small card utilization of <10%, and, of course, no late payments, your score should steadily climb back up.

      Reply

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