When it comes to personal finance, there are few topics that are discussed more often than credit scores. It doesn’t seem like a simple three-digit number would have that much impact on how you manage your money, but your score shapes whether you’re able to make a big purchase or qualify for the best rates on loans.
Carrying around a boatload of debt doesn’t do much to improve your score, but the way you pay it off could also have an adverse affect. If you’re trying to dig your way out from under high-interest credit cards, student loans or a car loan, taking steps to protect your credit score in the process is vital.
Pay debts in the proper order
Not all credit is created equally and one of the things that impacts your score is the mix of different credit types you owe. Revolving credit is a line of credit that can be used again, such as a credit card while an installment loan, such as a car loan or student loan, is meant to be used once and paid off. In terms of the impact each type of credit has on your score, revolving credit tends to weigh a little more heavily.
When you’ve got a choice between paying off a credit card or two and tackling an installment loan, you’re better off wiping out the revolving debt first. The reason? It has a more positive impact on your credit utilization ratio, which is the amount you owe compared to the total amount of credit you have.
When you pay down a revolving account, you have the option of leaving it open once the balance reaches zero. With an installment loan, the account is effectively closed once you’ve paid it off. Paying off the revolving accounts first positively improves your utilization ratio which can boost your score, whereas eliminating the installment loan first does neither and in some cases, can actually cause your score to drop.
Don’t rush to close accounts
Once you’ve paid off a credit card or other revolving account, you may be tempted to close it right away to avoid racking up any additional charges but you shouldn’t be so quick to pull the trigger. Approximately 15 percent of your FICO credit score is based on how long your accounts have been open and the longer your account history, the higher your number will be.
Closing accounts can also have a negative impact on your credit utilization ratio, especially if you still owe a balance when you cut up the card. As a general rule of thumb, you should be aiming to use no more than 30 percent of your total credit limit at one time.
If you have a $20,000 total line of credit, for example, and you owe $5,000, your utilization ratio would be 25 percent. Now, if you were to close a couple of cards with a combined $8,000 limit, you’d be reducing your total credit line to $12,000 and increasing your ratio to 41 percent. As your ratio goes up, your may see your score do the opposite so keeping those accounts open is a smart move.
Avoid opening new accounts
Opening a new credit card account or two is an easy way to increase your utilization ratio, as long as you’re not charging anything to the cards but it can hurt your score at the same time. Inquiries for new credit make up 10 percent of your FICO score and applying for multiple cards over a relatively short period of time can actually cause your number to drop. Not only that but it could send up a red flag with lenders, which could result in future applications for credit being denied.
Make all payments on time
Paying your bills late is the easiest way to send your credit score into a tailspin and when you’re climbing out of debt, you can’t afford to fall behind. Your payment history accounts for a 35 percent share of your FICO score and carries more weight than any other factor. Even one late payment could knock as much as 100 points off your score.
If you’re struggling to keep up with when payments are due, automating them through your bank ensures that you’re never late. If your bank doesn’t offer bill payment services or you primarily rely on a prepaid card to manage your money, you can still pay them online using an app like Evolve or Mint Bills. These apps also allow you to set up alerts so you’ll always know when your next payment is due.
Consider carefully when paying off old debts
The longer an unpaid debt remains on your credit report, the less it impacts your credit score. In most cases, unpaid debts and collection accounts will fall off your report after seven years. The new FICO 9 scoring model is set to reduce the impact of medical collection accounts that have eventually been paid off but that same benefit isn’t extended to other types of debt. Generally, paying off old debts won’t help your score any and it could have the opposite effect in certain situations.
For example, any time you agree to make a payment on a debt, you restart the statute of limitations. This is simply the amount of time a creditor has to sue you under your state’s law. If you were to negotiate a settlement for a debt payable in installments but you miss the last payment, the creditor could sue you for the balance. If they win a judgment against you, that goes against your credit, driving your score down even further.
If you’ve got some old debts hanging around, paying them off is the fiscally and morally responsible thing to do but you shouldn’t start writing out checks until you’ve determined how it could put your credit at risk.
Keep an eye on your credit report
Checking your credit report regularly while you’re in debt payoff mode is a must to ensure that your accounts are being reported properly. If you see any inaccuracies or erroneous information, you shouldn’t hesitate to initiate a dispute so the mistake can be corrected. Checking your own credit is considered a “soft pull” so you don’t have to worry about it hurting your score.