Debt payoff can be a helpful way to improve your credit score. But unless you win the lottery or you’re fortunate enough to come into a large sum of cash some other way, you probably need to pick and choose which accounts you’ll pay off first.
Reducing any type of debt might be a good idea from a financial standpoint. But if you eliminate certain debts before others, you may be able to raise your credit score faster. And while improving your credit certainly isn’t the only reason to pay off debt, it can be a nice bonus for your hard work.
So, the next question would be, "what debt to pay off first to raise my credit score?" Let’s dive into how to pay off debt to increase your credit score and all the factors to consider.
The accounts on your credit report typically fit into one of two major categories of debt—revolving or installment. These two types of debt represent very different ways to borrow money. Revolving and installment accounts also differ in the way they affect your credit score.
A revolving account is sometimes called open-end credit. This method of financing lets you borrow money from a lender, repay it and then borrow again as long as the account is open and in good standing.
Here are a few examples of revolving credit accounts.
Any account that appears on your credit report has the potential to impact your credit score. But revolving credit—and credit cards in particular—can be more influential.
Of course, payment history is the most important factor from a credit scoring standpoint.
Yet credit scoring models, like FICO® and VantageScore, may also reward you for using your credit cards sparingly.
When your credit utilization rate stays low (meaning you use less of your available credit card limit), your credit score should benefit. But if you run up a balance and utilize a higher percentage of your credit card limits, those actions may damage your score.
An installment loan is a type of closed-end credit. You borrow a set amount of money from a lender that issues the funds to you on a one-time basis. Then you repay a fixed amount each month until you satisfy the debt. If you want to borrow more money down the road, you’d need to apply for a new loan. Most lenders still take into account the 5 c’s of credit when approving any of your loans.
Here are some examples of installment loans:
Installment loans affect your credit score in a different way than revolving accounts. It’s still important to keep each monthly payment on time (as it is with every account on your credit report). But owing a balance on an installment account—even a large balance—isn’t likely to hurt your credit score the way it might with a revolving account.
There’s a simple explanation for why a credit scoring model penalizes those with higher revolving utilization rates on their credit reports. It’s a matter of math.
Statistics show that people who use a lower percentage of their credit card limits represent less risk to lenders. Meanwhile, owing outstanding balances on installment loans (even high balances) doesn’t indicate higher credit risk.
The job of a credit scoring model is to help lenders predict risk—the risk that you’ll fall 90 days or more behind on a credit obligation in the next 24 months. If you have a higher credit card utilization rate, the math says you’re more likely to default on your debts. Therefore, you would earn a lower credit score.
As you can see above, high credit card balances (relative to your credit limits) could damage your credit score—sometimes a lot. But installment debt typically won’t have the same negative score impact. If your primary goal for getting out of debt is to boost your credit score, your credit card accounts are probably where you’ll want to focus your attention first.
Yet even if you decide to tackle your credit card debt first, you can go a step further with your debt elimination strategy. You can pay off your credit card balances in a particular order to potentially see credit score improvement even faster.
The snowball strategy is a debt elimination method with the potential to help your credit score. With the debt snowball approach, you make a list of your credit cards from the highest balance to the lowest balance. See below.
Next, you make the minimum payment on every account, except the card with the lowest balance. You pay every dollar you can afford on the lowest-balance card—hopefully much more than the minimum payment due.
Once you pay off the card with the lowest balance, you move up to the next lowest balance on your list (QRS Bank, in the example above). Finally, repeat the process until you pay off all of your credit card debt.
The reason the snowball strategy might improve your credit score faster is that scoring models consider revolving utilization on:
When you pay off a credit card, you lower your revolving utilization rate on that account to 0%. You also lower your aggregate utilization rate by some degree as well. This could help you twice from a credit score standpoint.
Some people prefer the debt avalanche method for paying down credit cards. It involves paying off the card with the highest interest rate first, then moving down the list. The debt avalanche might help you save more in interest—at least in the short term—but it’s not the best approach if your main goal is to see your credit score rise ASAP.
Paying off a loan might be a smart financial move (after you tackle those high-interest credit cards). However, reaching a $0 loan balance doesn’t guarantee credit score improvement. In some cases, paying off a loan might trigger a temporary score drop instead.
If you experience a credit score drop after paying off an installment loan, it might be due to one of the following reasons.
Some people believe paying off a loan will cause you to “lose credit” for the age of the account once the account status changes to closed on your credit report. That’s a myth.
Credit scoring models do consider your length of credit history and your average age of accounts when calculating your credit score. However, closed accounts remain on your credit report for up to ten years if they’re positive and up to seven years if they’re negative. As long as an account appears on your credit report—open or closed—it will factor into your average age of credit.
Paying off installment debt (like a personal loan, auto loan, or mortgage) isn’t guaranteed to improve your credit score. But when you pay down credit card debt and reduce your credit utilization ratio, you’re likely to experience at least some degree of credit score boost. The question, however, is how long will it take for your credit score to go up?
In many cases, you may see your credit score improve within 60 days or less after paying off credit card debt. It all depends on when your credit card issuer updates your account information with the credit reporting agencies (Equifax, TransUnion, and Experian).
The account information on your credit report doesn’t update in real-time. If you were looking at a live picture of your credit report, the balance on your credit card wouldn’t automatically increase every time you make a charge, nor decrease when you make a payment.
Instead, your account information changes when your card issuers update the credit bureaus—typically at the end of each billing cycle. Once a credit bureau receives updated information and adds it to your credit report, you can expect to see any potential adjustment in your credit score the next time you check it.
It’s worth noting that other information could change on your credit report while you’re waiting for your credit card balance to update. So, if your credit score doesn’t go up like you hoped after paying down a credit card, you may want to check the rest of your credit report to see if any new, negative information counteracted your debt elimination moves.
The average American owes $5,897 in credit card debt, according to Experian. (In certain states, like parts of California, the average credit card debt per household is much higher.) Meanwhile, a Federal Reserve study found that 39% of adults would have difficulty covering a $400 unexpected expense.
When you consider these figures together, it paints a picture. Many people are not in a financial position to put hundreds of extra dollars toward paying down credit card debt each month.
If you want to get out of debt but don’t have much extra cash, debt consolidation might benefit you. When you consolidate debt, you borrow money again to pay off money that you borrowed before. However, debt consolidation aims to secure a lower interest rate so that you can speed up the payback process.
There are two primary types of debt consolidation:
Below is a look at each of these options.
Debt Consolidation Loan
A debt consolidation loan is a type of personal loan you use to pay off existing debt. If your credit is in decent shape, you may be able to qualify for a personal loan with a lower interest rate than you’re paying on the debt you already owe. It may be possible to get a debt consolidation loan with bad credit as well. But the fees, interest rates, and other loan terms generally won’t be as attractive.
When you use a debt consolidation loan to pay off revolving credit card debt, you may be able to lower your utilization rate quickly. By converting revolving debt to installment debt, you might see an increase in your credit score even before eliminating the debt for good.
With a balance transfer, you use a new or existing credit card to consolidate your debt. If your credit is in good standing, you might qualify for a new credit card with a low rate or even 0% APR introductory offer on balance transfers. Existing credit cards may offer you a chance to transfer over balances from other credit cards or loans at a temporarily reduced rate as well.
Perhaps the biggest appeal of a credit card balance transfer is the chance to save money. Even with the addition of a balance transfer fee (often 3%-5% of the amount you transfer), there may be an opportunity for significant savings. (Tip: Crunch the numbers with a balance transfer calculator to be sure moving debt to a new credit card makes good financial sense.)
If you open a new credit card and transfer balances from existing credit cards to it, you might also lower your credit utilization rate—though probably not as much as you’d lower it with a debt consolidation loan. Still, when your credit utilization rate goes down, it’s typically good for your credit score.
Debt consolidation loans and balance transfers both have the potential to help you eliminate debt faster. Yet, it’s critical that you avoid taking on new debt with either approach. It’s a bad idea to transfer balances away from existing credit cards, and then charge up new balances on those accounts again.
If you’re overwhelmed by debt, or if you don’t think you can avoid overspending on your credit cards after a consolidation, you might want to consider talking to a reputable credit counseling agency about a debt management plan instead. But if you can commit to only using your credit cards for charges you can afford to pay off each month, consolidating your debt might pay off in the long run.
Michelle L. Black is a leading credit expert with over 17 years of experience in the credit industry. She’s an expert on credit reporting, credit scoring, identity theft, budgeting and debt eradication. See Michelle on Linkedin and Twitter.
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