If you are considering applying for a loan, or you just want to improve your credit, you may be wondering, "Will paying off my debt help my credit?" The answer to this question is a resounding yes.
Why Will Paying off My Debt Help My Credit?
When asking the question, "will paying off my debt help my credit?" most people are referring to their credit score. This score -often called a FICO score after the Fair Isaac Corporation which pioneered the scoring formula- is a three digit number between 300 and 850. Few, if any, individuals have a 300 FICO score or an 850 FICO score. As of 2010, scores above 700 are generally considered good-to-excellent, while scores under 680 are fair and scores below 620 are considered poor.
Your FICO score is determined by five major categories. Although each of the three credit bureaus- Equifax, Experian and TrasUnion- compute your score somewhat differently, they all use this basic formula.
The major components of your FICO score include:
- Payment history: This accounts for 35 percent of your score and consists of your record of payments, and a list of any judgments, accounts sent to collection or bankruptcies.
- Amounts Owed: Also referred to as debt-to-credit ratio, this factor refers to the amount you owe and the amount of available credit you have used. It accounts for 30 percent of your FICO score. This factor is the reason paying off debt will help your credit.
- Length of Credit History: This factor refers to the average time your accounts have been opened, and comprises 15 percent of your score.
- Types of Credit Used: This factor, which accounts for 10 percent of the score, refers to your mix of credit products.
- New Accounts: This final ten percent deals with the amount of new credit accounts you open.
Your Debt-to-Credit Ratio
The reason paying off debt helps your credit score is because lowering your balances has a positive effect on your debt-to-credit ratio. When you are issued credit, your creditor gives you a maximum credit line. This is also referred to as your credit limit. You can charge up to this limit. Lenders, however, do not like to see "maxed out" cards, or cards charged up to your limit. If you use a high percentage of your available credit, it can indicate poor financial management skills. It can also signify that you may begin to have trouble making payments. For this reason, a high credit utilization can cause your credit score to drop.
Most experts recommend keeping your credit utilization at around 30 percent in order to achieve the best credit score possible. If you have used more than 30 percent of the credit available to you, then paying off this debt will definitely help your credit score.
How to Improve Your Debt to Credit Ratio
In addition to improving your debt-to-income ratio, paying off debt by making a series of on-time payments can also have a positive impact on the payment history component of your score. Even making the minimum payments on time is sufficient to achieve a good score.
Raising Credit Lines
Debt reduction can be a time consuming process. Shifting your budget or earning extra income to send in additional debt payments can be a useful way to pay down your debt faster, but isn't always possible.
People looking to improve their credit scores may instead consider raising their credit limits. By doing this, you also alter your debt-to-credit ratio to a more favorable number. Since your credit limit is higher, the balance you have on your cards is lower in relation to the new limit than it was to the smaller limit.
However, be aware that when you apply for a credit line increase or apply for a new credit card, this can actually hurt your score by lowering the average age of your accounts (if you open an entirely new account) or by displaying as an inquiry (a request for new credit) when you ask your existing lenders to raise the limits on your cards.
If your lender is willing to raise your credit limit without running a credit check, this can be a shortcut to improving your debt-to-credit ratio while you pay down debt, since you won't have an inquiry but you will have a better debt-to-credit ratio. Not all lenders are willing to do this, but if you have been a good customer and have a history of on-time payments with your lender, it is worth a phone call to ask.
Achieving Good Credit
Achieving a good credit score is definitely a worthwhile endeavor. Having a high score can save you thousands in interest over your lifetime as you get preferred rates on mortgage payments and car loans.
While paying off debt can seem like an arduous process, it is worthwhile to improve your financial situation. Plus, you'll have the added benefit of paying less in interest if you pay off your debt faster.