Many methods can be used to pare down debt, but not all have the same impact on lowering your credit score. If your credit score is a concern -- like if you’re planning to apply for a mortgage within a few months -- you'll want to look at your report and see what’s doing the most damage to your score. While each credit profile is different, in many cases paring down the balances on multiple accounts has more of an impact than paying off one loan entirely.
How it Helps
Paying off debt improves your credit score several ways. In addition to reducing your obligations, it improves your credit utilization ratio, which measures the amount of debt you have in comparison to your available credit. As a result, you’re using less of your credit line and managing that credit better. Start any repayment plan by making sure none of your accounts is delinquent, as any accounts that aren’t current drag down your score.
Spread Payments Around
To boost your credit score the most, spread payments out among multiple cards rather than paying off a single account. That’s because your FICO credit score considers not your overall credit utilization ratio, but that of each individual account. Getting all of your cards below 30 percent utilization helps your score more than paying off one card and having four others with high utilization rates. While the snowball method -- which requires paying off one debt first and then using the savings to pay off the next one -- is an excellent way of reducing your debt, its effect on your credit score is less pronounced in the short term.
Pick the Right Debts
If you have limited funds to pay off debt, start with the credit card account that’s the most maxed out. Lowering that utilization ratio can remove one of the bigger red flags on your report. On the other hand, debt like a mortgage or student loan is seen as a more positive use of credit. Both can help you improve your financial position because of the investment in real estate and in yourself, and both reflect long-term planning over short-term impulses.
Keep Accounts Open
While paying off your debt improves your credit score, don’t close your older accounts. The length of your credit history counts for 15 percent of your credit score, and once you close your account it starts the process of aging off your credit report. If your debt is truly old -- like if there’s an account that appears as a charge-off that’s six years past due -- you might be better off not paying it at all. Most debts age off your credit report after seven years, so paying it off actually keeps it on your record longer in such cases.
An increase in your credit score might not happen immediately. The multitude of variables that go into calculating your score makes gains or losses difficult to predict. It is best to plan on paying your debts off a few months before you plan on a major purchase to give your creditors a chance to report the payments, and allow your credit score to rise as your obligations decrease.
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