Review your credit score and scoring factors to find out which accounts you should pay off first. Debts that are past due and credit card debt with high interest rates should be paid off first if you want to improve your credit score.
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
Take a look at what makes up your credit score before you read about how paying off debt affects credit. Equifax, Experian, and TransUnion are the three main credit bureaus. They all use scoring models that look at five main things.
- 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 parts of your credit score is how often you’ve paid your bills on time. If you have debt, your monthly payments are a chance to build your payment history. Each on-time payment looks good on your credit report.
If you don’t make payments on time, it can hurt your credit score. Paying off a debt protects your payment history by removing the risk of missed or late payments. Once the debt is paid off, the account will show as “paid as agreed” or “paid in full,” which is a good thing.
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 mortgage or car loan, the account will be closed and removed from your credit report. If it’s an older account, this can make your credit history look younger on average.
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 score is based on what’s in your credit report, and paying off or lowering a debt may have different effects for different people. 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 keep your credit scores from dropping even more.
- Collections: Some of your credit scores might go up if you pay off or settle collection accounts. Newer credit scoring models ignore paid-off collections accounts.
- Credit cards: If all of your other bills are paid on time, you should focus on paying off your credit card balances. Credit utilization is a big part of your credit score because it shows how much of your available credit you’re using. Do not carry credit card debt from month to month. If you pay your balance off early, it may lower your reported balance and improve your credit scores.
- Installment loans: Paying off an installment loan might raise your credit score, but sometimes it will actually lower your score slightly.
Learn more: How to Improve Your Credit Score
Paying Collections – Dave Ramsey Rant
FAQ
Does paying debt improve credit score?
Yes, paying down or off debt can improve your credit score, but the impact varies. Generally, consistently paying down debt, especially past-due accounts and credit card balances, is beneficial for your credit health.
How quickly does credit score go up after paying off debt?
Paying off debt can lead to a credit score increase, but the timing varies. Generally, you might see an improvement within 30 to 60 days after the debt is paid off and reported to the credit bureaus.
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.