Review your credit score and scoring factors to find out which accounts you should pay off first. As a general rule, prioritize past-due accounts and high-interest credit card debt over installment loans if you want to improve your credit.
If youre focused on improving your credit scores, paying down or off certain debts can be an effective route. For many people, focusing on past-due accounts, collection accounts and revolving debt, such as credit card debt, might offer a quick win. However, your unique situation will dictate which debts you should pay off first.
Paying off debt can certainly help build your credit, but it’s a bit more nuanced than that. Here’s a detailed look at how paying down debt affects your credit score.
How Credit Scores Are Calculated
Before diving into how paying debt impacts credit it’s important to understand what makes up your credit score. The three major credit bureaus – Equifax Experian, and TransUnion – use scoring models that take into account five key factors
- Payment history – Whether you pay your bills on time. This has the biggest impact on your score.
- Credit utilization – The ratio of credit you are using compared to your total available credit. Using too much of your available credit can lower your score.
- Credit history length – The longer your credit history, the better.
- Credit mix – Having different types of credit – revolving (credit cards) and installment (auto, mortgage loans) – can help your score.
- New credit – Opening several new credit accounts in a short time can lower your score.
So how does paying down debt fit into these categories? Let’s take a closer look.
Paying Debt Improves Payment History
One of the most important factors in your credit score is your track record of on-time payments When you have debt, those monthly payments provide an opportunity to build your payment history Each on-time payment is reflected positively on your credit report.
Conversely, missing payments can seriously damage your score Paying off a debt eliminates the risk of missed or late payments, protecting your payment history Once paid in full, the account will show as “paid as agreed” or “paid in full” which has a positive impact.
So in this regard, paying down debts – especially those you may have struggled with in the past – helps demonstrate responsibility and improves this key scoring factor.
Paying Debt Reduces Credit Utilization
Your credit utilization rate is the ratio of how much credit you are using compared to your total available credit. As a rule of thumb, experts recommend keeping this below 30%.
Paying off credit card balances or an installment loan lowers your overall utilization, freeing up credit. This can provide a nice boost to your credit score, especially if your utilization rate was getting too high.
One note though – you don’t necessarily have to pay a debt completely. Even paying a portion to get your utilization to a lower percentage can help. The impact comes from owing less on your current credit lines and having more available credit.
Closing Accounts Can Lower Length of History
When you pay off an installment loan like a car loan or mortgage, that account will eventually be closed and fall off your credit report. This can lower the average age of your credit history if it’s an older account.
Having long-standing credit accounts demonstrates stability to lenders. Closing your oldest account could have a small negative impact on this scoring factor. However, as long as you still have other long open accounts, the effect is usually minor.
Paying Debt Can Reduce Credit Mix
Lenders like to see you managing different types of credit – both installment loans and revolving credit cards. If paying off an installment loan means closing your only source of this type of credit, your mix of accounts shrinks.
This is easily addressed by making sure you still have open installment loans reporting on your credit – for example, a mortgage or student loan. As long as you have at least one active installment loan, this factor should not be affected.
Paying Off Debt is Worth the Temporary Score Drop
As you can see, under certain circumstances, paying off a debt could cause your credit score to drop slightly. However, this is temporary and minor compared to the long-term benefits of being debt-free.
Your credit score will quickly rebound and the positive payment history will have a greater impact over time. More importantly, you’ll have the peace of mind that comes from eliminating debt as well as lower monthly expenses.
The takeaway? Don’t let fear of a small score drop stop you from paying off debts, especially those charging high interest rates. Pay them off as quickly as possible while continuing to demonstrate responsible credit habits. This balanced approach will have you building solid credit in no time.
How to Pay Off Debt
Choosing which debt to prioritize can be important, particularly when you want to quickly improve your credit scores. However, you can also strategize your approach to help you get out of debt sooner or pay less overall.
A General Guide to Which Debt to Pay Off First
Your credit scores depend on whats in your credit reports, and the impact of paying down or paying off a debt can vary depending on your situation. If your goal is to improve your scores, you might want to focus on the following factors:
- Past-due accounts: Getting open accounts that are past due back into good standing can minimize further damage to your credit scores.
- Collections: Paying off or settling collection accounts could improve some of your credit scores. Newer credit scoring models ignore paid-off collections accounts.
- Credit cards: If all your accounts are current, shift your focus to paying down credit card balances. Credit utilization is an important credit score factor that measures the amount of your available credit youre using. Even if you dont carry credit card debt from month to month, making early payments could decrease your reported balance and might help your credit scores.
- Installment loans: Paying off installment loans might help your scores, although there are times when paying off the loan will actually lead to a minor score drop instead.
Learn more: How to Improve Your Credit Score
Paying Collections – Dave Ramsey Rant
FAQ
Does paying debt improve credit score?
How quickly does credit score go up after paying off debt?
How much will my credit score go up if I settle a debt?
In the short term, settling a debt usually won’t boost your credit score, and it could actually hurt it initially. When you settle a debt, it means you’re paying less than what you originally owed to the creditor — often 30% to 50% less — to get rid of the debt.
How many points will my credit score go up if I pay off a debt?
Your credit score could increase by 10 to 50 points after paying off your credit cards. Exactly how much your score will increase depends on factors such as the amounts of the balances you paid off and how you handle other credit accounts. Everyone’s credit profile is different.