There’s no doubt that any progress toward eliminating your debts is a smart move, both for your credit reports and your wallet. However, it’s even smarter to pay off your debts in the right order. Knowing which debts to target first, and which debts to leave for later, could potentially save you a lot of money, get you out of debt faster, and boost your credit score, too.
Should you pay off your student loan first, or tackle your credit card balances? What about your mortgage, auto loan, or personal loans? While there’s no “wrong” way to pay off your debt, there are definitely some strategies that might help you to improve your credit scores sooner rather than later.
- Related: Five Perks of Having Good Credit
Start With Your Credit Cards
Generally speaking, it’s best to start with your credit card accounts when you’re ready to begin paying down your debt. Not only are these debts likely the most expensive you’ll ever carry, with interest rates in the high teens or higher, but carrying large balances on your cards will also have a negative impact on your credit scores.
Credit scoring models like FICO and VantageScore are designed to pay attention to the debt-to-limit ratios on your credit card accounts. This relationship between the credit card balances displayed on your credit reports and your account limits is formally known as your revolving utilization ratio.
When your revolving utilization ratio climbs because your balances start getting too close to your limits, you’ll generally end up with a lower credit score. In fact, 30% of your credit score points are based on that debt-to-credit-limit ratio.
As a result, when you begin to pay down your credit card balances, lowering your revolving utilization ratios, your credit scores will generally begin to climb. That fact, plus the high APRs, typically make credit card balances the perfect place to start when you’re ready to begin paying down debt: It’s a one-two financial punch that can simultaneously raise your credit score and save you big bucks on interest payments.
Start With the Smallest Balances
So you should probably begin your debt elimination journey with your credit card accounts. But which credit card should you pay off first?
You probably want to work your way up from the bottom. First, make a list of all of your outstanding credit card debts, from the smallest balance to the largest:
- ABC Bank: $500 balance
- QRS Bank: $4,000 balance
- XYZ Bank: $5,500 balance
By paying off the smallest balance first (ABC Bank in the example above), you’ll accomplish two important things: First, you’ll reduce your number of total accounts with balances. Second, you’ll bring the revolving utilization ratio on an individual account down to 0%. Credit scoring models will generally reward you for both of these actions.
Once you’ve paid off the smallest balance, you can move on to the next largest balance and repeat the process. This actually dovetails with the “Debt Snowball” approach to debt elimination, helping you build and maintain momentum with small victories in the critical early stages of debt reduction.
Just remember to continue making at least the minimum payment on all of your accounts to avoid late fees and potential credit score damage.
What About Installment Loans?
Most of the non-credit card accounts appearing on your credit reports will probably be installment accounts. These debts feature a fixed payment scheduled over a specific period of time. Mortgages, auto loans, and most personal and student loans fall into this category.
Because installment loans are not as indicative of future risk as credit card accounts, credit scoring models don’t pay as much attention to the balances on these types of accounts. The initial impact of installment debt on your credit scores is not going to be significant. As a result, paying off such debts probably is not going to have a positive impact on your credit scores either.
Of course, it can still be a sound financial move to pay off installment debts (especially if you’ve already tackled your credit card balances). But you should have realistic expectations about how big an impact paying off installment debt may have on your credit scores — which won’t be much, if any.
Related Reading:
- In What Order Should I Pay Off My Debts?
- Should You Use a Personal Loan to Pay Off Credit Card Debt?
- Revolving Debt vs. Installment Loans: Why the Type of Account Matters to Your Credit Score
John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. He has written four books on the topic and has been interviewed and quoted thousands of times over the past 10 years. With time spent at Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.
The post Which Debts Should I Pay Off First to Raise My Credit Score? appeared first on The Simple Dollar.
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