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An In-Depth Guide on How to Pay Off Debt and Improve Your Credit Score in the Process
General Guide to Which Debt to Pay Off First to Raise a Credit Score
Debt is like gaining weight. For many people, an extra treat here and a little splurge there don’t seem like real problems.
Over time, though, bits and pieces add up and one day they wake up and say, “How did that get there?”
The good news is that it’s not too late. Paying off debt and improving a credit score are two of the most common financial goals. For people who do it right, they can score wins on two goals at the same time.
Below are answers to the most common debt and credit questions, from expert tips to which debt to pay off first to boost your credit score.
How Debt Payments Can Improve a Credit Score
Big debts and bad debt often go hand in hand. So it’s nice to know that working on one goal can also help another.
Improves Utilization Ratio
One of the many factors that affect a credit score is a person’s credit utilization ratio. This is the percentage of revolving credit they use.
Revolving credit is any credit that a person can use over and over again such as credit cards. If a credit card has a limit of $10,000, a person can use the credit, pay it off, then use it again.
This is different from a car loan, for example. If someone gets a $20,000 car loan and they pay off $5,000 of it, they can’t later use that $5,000 for something else.
It is easy for people to calculate their own credit utilization ratio.
First, they must add credit limits to all their credit cards. Next, they add up the balances of all the cards. If they divide the total balance by the credit limit, that’s their credit utilization percentage.
The goal is to get the utilization ratio below 30%. But, the lower the better. Every dollar of revolving credit a person pays improves their utilization ratio.
Establishes a Record
Another important part of a person’s credit score is their payment record. The reason people have bad credit when they first turn 18 is that lenders don’t have a record to tell them if the teen pays their bills on time.
Let’s say it takes a person two years to pay off their debt. That’s two more years of reliable payments on their record, which will improve the credit score.
Helps the Debt-to-Income Ratio
In fact, it does not directly affect a person’s credit score. However, one of the most common reasons people are trying to pay off debt and raise their credit score is because they are trying to buy a home. Their debt-to-income ratio plays a big role in their loan eligibility.
As one might expect, the debt-to-income ratio calculates the percentage of a person’s monthly income that must go toward debt. This is based on their minimum payments, not the amount they choose to pay.
With some debts like credit card debt, the minimum payment goes down as the balance goes down. The result is a better debt to income ratio.
What Debt to Pay Off First to Raise a Credit Score
It is clear that paying off debt can improve a person’s credit score in many ways. For most people, however, their debt includes many types of accounts. Here’s how to prioritize.
A credit score doesn’t just look at how much debt a person has but also the types of debt they have. They can categorize accounts into “good debt” and “bad debt.”
Good debt includes a mortgage and student loans. Investing in a house or a degree can improve a person’s financial situation in the future, making it possible for these loans to be fruitful.
Bad debt, on the other hand, has no ability to improve a person’s financial situation. That includes credit card debt and personal loans. To increase their credit score, a person should focus on bad credit before good credit.
Consideration of Utilization Ratios
For someone trying to pay off their debt in a way that will help their credit score the most, they should keep their utilization ratio in mind. It is best to pay off their revolving credit before other debts.
For example, if someone has credit card debt as well as a car loan, they should pay off their credit card debt first.
Tips for Paying Off Debt and Raising a Credit Score
Even when people know which debts to pay off first, it can be difficult to know the next steps. These tips will help.
Higher Interests Should Be Higher Priority
As mentioned above, it is important to pay off credit card debt first. For people with multiple credit cards with high balances, however, they should focus on the one with the highest interest rate first.
If all credit cards have the same or similar interest rates, it’s best to start with the one with the highest balance. This way, the person lowers their maximum monthly interest payment from the beginning.
The Snowball Method Helps with Motivation
In general, it’s better to pay off larger and more interest-bearing debts first. For some people, however, it can be discouraging to take a long time to cross a debt off their list.
Those who need more motivation can start with the snowball method.
In this method, they continue to make minimum payments on all their accounts but they put more money towards their smallest debt. It’s easier to see progress and stay motivated this way.
Think Twice About 0% Interest Cards
There is a common trick for paying off high interest credit card debt. This includes applying for and receiving a new credit card with a 0% introductory interest rate. The person transfers their debt to that card so they don’t pay interest while they pay it off.
That’s a great tactic if paying off debt is the only priority. However, it can damage a person’s credit score in the process. For one, adding a new credit card can lower the average age of their accounts, which can hurt their credit score.
It is also common for people who do this to close the credit card with the original debt. If they do this, it will likely hurt their credit utilization ratio because there is a possibility that the new card will have a lower credit limit.
Achieving Better Financial Standing
Paying off debt and improving a credit score doesn’t just take money. It also requires some research, such as knowing what debt to pay off first in order to raise the credit score. The above tips can help anyone solve their financial goals quickly.
For a more hands-on approach to credit repair, our credit repair experts can help.
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