Will Paying Off Debt Help My Credit
While paying off credit card debt will increase your credit score because it decreases your credit card utilization rate, that is not always the case with other types of credit.
In the case of credit card debt, when you pay down your balance, you are decreasing your credit card utilization rate. That is the percentage of open credit you have used and one of the bigger factors in determining your credit score.
Mortgage, auto loans, and other common loans, like student loans, are installment loans. You pay them over off over a specified period of time. When you pay off these loans, they typically close the account which may shorten the length of your overall credit history. The length of your credit history is another factor in determining your credit worthiness.
On the other hand, if you have old collection accounts, paying these off will not impact your score at all. There is one caveat. If you have negotiated well and have entered into an agreement with the collection agency to remove the collection account from your credit in exchange for payment, you may be in luck.
Let’s dig into when it is beneficial to pay off your debt and how it impacts your credit score.
The Different Types of Credit
Most credit can be placed into two categories; revolving credit or installment loans. Revolving lines of credit can be used, paid down and be used again. Credit cards, store cards and home equity lines of credit are examples of revolving credit. Home equity lines of credit are secured by the equity in your home while credit cards and store cards are typically not secured, but can be.
Installment loans, however, typically have a set payment amount for a specific term, but can have a variable payment as well. Once the loan is paid off it is closed out. Installment loans can also be secured by property or not. For instance, a car loan is a secured installment loan whereas student loans are typically not secured.
Now that we have a better understanding of the types of loans available, it is also important to understand the factors credit reporting agencies use to determine your score.
How Debt Affects My Credit Score
Your credit score, which is a measure of your creditworthiness, is impacted by five core factors.
- Payment History
- Credit Utilization Rate
- Length of Credit History
- Mix of Credit
- Number of Recent Credit Inquiries
Your payment history makes up the biggest percentage of your credit score at 35%. It is a measure of how many times you have paid your accounts late. Creditors typically report past due balances once they become at least 30-days late and continue to report as late until they are current. Recency, number of late payments, the amount owed and the length of the time late are all factors the credit reporting agencies examine.
One or two late payments over two years old will not have as big an impact on your score as five late payments from 3 months ago.
Accounts referred to collection agencies, bankruptcy, foreclosures, judgements and charge-offs all have a negative impact on your credit as well.
Bankruptcies remain on your credit for 10 years, while almost all other negative reports remain for 7 years.
ACTION STEP: One of the best ways to improve your credit is to keep your account current and not make any late payments from this day forward.
Credit Utilization Rate
Your credit utilization rate makes up 30% of your credit score. This is the second biggest factor in determining your credit score. Your credit utilization rate is how much you have used of your revolving lines of credit or your open credit.
Creditors prefer to see no more than 30% of your open revolving lines of credit used. So, it is important to pay off your balances monthly or, at a minimum, do your best to keep them below 30% at all times.
For instance, 25% of a 1,000 credit limit would mean your balance should not exceed $250.00.
The higher your utilization rate, the bigger perceived credit risk you are to creditors.
ACTION STEP: Begin paying off balances on revolving lines of credit and at a minimum get your credit utilization rate under 30%.
Length of Credit History
The older your accounts are, the more history a creditor has to evaluate your credit worthiness. They have a bigger picture of what type of risk they encounter when they offer you credit. Your Credit History accounts for 15% of your credit score.
Action Step: Keep your oldest accounts open if possible and keep new accounts to a minimum.
Mix of Credit
Your mix of credit measures what types of credit you have. In addition to the length of your credit, creditors are also looking to see how you have handled different types of accounts. Your mix of credit makes of 10% of your score.
This does not mean you need to immediately go get a car loan, installment loan and a mortgage in addition to the credit cards you already have, just understand that the mix of credit you have will impact your score.
Action Step: Keep a good mix of credit
Finally, the last measure of your credit score is the number and recency of new applications for credit you have. These account for the final 10% of your score.
Applying for too many new accounts at once may signal to creditors that you are in financial distress.
The good thing is that it is measured only one time for each category of credit in a 30-45 day period. Creditors understand that you may need to shop for rates when making a purchase or refinance and when doing so there may be multiple inquiries very close together.
An example would be when you are looking to refinance your house. You might have inquired with 5 different brokerages in one month. The good news is it will only count one time.
Inquiries over two years old fall off as well, so the older the inquiry the less impact it has. Unless you are looking at your FICO score; FICO drops inquiries after one year.
You should keep the number inquiries to under two.
Action Step: Keep new inquiries to a minimum
Why Did My Credit Score Drop?
Installment Loans vs. Revolving Accounts
How Paying Off an Installment Loan Affects Your Credit
Paying off an Installment loan versus a credit card impacts your credit differently and that is because each affects a different score factor.
When you pay off an installment loan, it typically closes the account. When an account is closed it takes that account out of the credit history portion of your score. It will stay on your credit report but may reduce your overall length of credit.
For instance, if you have a 10 year installment loan and you pay it off in seven years and all of your other credit is only two years old, you have significantly reduced the length of time your oldest account has been open because the ten years is no longer counted.
Additionally, when you pay an installment loan off early, you are taking away profits from the creditor and this can be viewed negatively by prospective new creditors.
Most agree that, even though paying off installment loans will impact your score, the impact is minimal and your score will likely recover quickly.
How Paying Down Revolving Credit Affects Your Credit
As you know by now, the balance of your revolving credit impacts your credit utilization rate. If you have maxed out all of your credit cards and/or other revolving accounts, you have a high credit utilization rate and your score will decrease.
Likewise, if you want to increase your score, paying down your balances is one of the best ways to do that.
It is best to pay off your revolving accounts every month and, if not able, at least keep your utilization under 30% of your credit limits.
Will I Improve My Credit If I Pay Off My Collection Accounts?
The answer to that question is, it depends.
Simply paying off an old collection will not improve your score. The simplest explanation is that the damage has already been done. You can’t undo your late payments….except that you might be able to, if you do one thing.
Negotiate. There is a saying that “everything is negotiable.” That goes for your collection accounts too. If you are considering paying these accounts off, before you agree to do so, have the creditor agree to remove the collection from your credit report in return.
As with all agreements – be sure to get the agreement in writing before sending any money.
Why You Still Might Want To Pay Off Collection Accounts
If the creditor will not agree to remove the account from your credit report, there may still be several reasons to pay if off anyway. These include:
- You’ll feel better having honored your debt
- You want to avoid being sued
- You want to avoid wage garnishment
- It may make you appear more responsible to some creditors even though it doesn’t impact your score
- The Statute of Limitations has not expired on the debt
Statute of Limitations
The statute of limitations determines how long a creditor may legally pursue a borrower for a debt. It typically begins once the default has occurred (the non-payment). Keep in mind that every state is different, so you will need to do your own due diligence for your state. In some states this may be as little as three years and in others as long as six years or more. A promise to pay will also restart the clock in most instances as well. Again, do your own due diligence in determining whether or not the statute of limitations has expired on the debt. A valid defense to a claim by a creditor is that the statute of limitations has expired.
(Nothing in this article is to be construed as legal advice – you should consult with an attorney in your own state to discuss your specific circumstances and how to proceed.)
Your credit score is important for many reasons, not only does it effect your future ability to receive credit as well as the terms you are offered, there are other non-financial reasons to have good credit as well. We hope this information has been helpful to you.
Love and Prosperity,
Wendy and Curtis
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