It’s perfectly normal to be worried about your credit score. After all, you’re constantly told that having a good credit score is important for a huge variety of reasons. It’s also a point of pride for many people.
So what do you do when your credit scores are sinking like the Titanic because you’ve hit the “debt iceberg?”
You don’t have to let your credit score sink to the ocean floor or pay people to do credit “repair”. There’s a simple solution that will greatly benefit both your credit AND you: focus on paying off your debt.
Making consistent, on-time payments that reduce your balance is a surefire way to help repair & improve your credit score.
What is a credit score, and how is it calculated?
Before we get into why paying off debt works to help repair your credit, let’s talk about the kinds of things that make up a credit score. It’s important to know that to understand just how paying off debt can help.
Thanks to some excellent marketing, many people don’t realize that your credit score is about debt. It’s another way of saying “existing debt and potential new debt, plus how you act as a borrower.” That’s because credit is all about two things:
- your ability to borrow,
- and how you’ve handled repaying money you’ve already borrowed
Your credit scores are a shorthand way of telling potential lenders how good of a borrower you might be. (At the moment that they pull a score.)
Two of the most commonly-referenced types of credit scores are FICO scores and VantageScore. You have multiple credit scores, even multiple FICO scores, and they change constantly.
What influences a credit score?
According to myFICO, their credit scores are comprised of five different factors:
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
VantageScores are similar, with the following factors making an impact:
- Payment history (extremely influential)
- Age and type of credit (highly influential)
- % of credit limit used (highly influential)
- Total balances/debt (moderately influential)
- Recent credit behavior and inquiries (less influential)
- Available credit (less influential)
Notice how the top few factors (payment history, amounts owed, and how much of your credit limit you’re using) have a HUGE impact on your credit score. 65% in the case of a FICO score.
Watch out for these things
If you have a high balance on a credit line compared to your credit limit, your credit score will be lower. Reducing your balance there improves both your amounts owed and your percentage of credit line used.
If you’ve had one or more late payments reported in the past, your score will be damaged. Significantly, if you’ve been 60+ days late on a debt or you’ve been late on a house payment. If you don’t make minimum monthly payments on time or at all, your credit score gets penalized monthly. When a missed payment is reported to one of the credit reporting agencies, it stays on your credit report for up to seven years!
If your debt is turned over to a collections agency or enters default status, that also stays on your credit report for up to seven years. It damages your credit score even more.
If you want to improve your credit score for a mortgage…
Many people want to improve their credit score so they can get a mortgage. (Even though manual underwriting is an option too.) For a mortgage you apply for the usual way, the total amount of debt you have compared to your income in matters too. Lenders look at your debt-to-income ratio, and the more debt you have, the higher your debt to income ratio is. (Lower is better!)
In fact, every single factor that influences a credit score directly relates to how you handle debt. Remember to avoid companies that promise to do things like erasing bad credit, giving you a completely new credit file, or removing accurate reports. The old adage that “if it sounds too good to be true, it probably is” is a well-known saying for a reason.
How does paying off debt help?
Paying down debt helps your credit score in a variety of ways.
As the amount you owe on a revolving credit line decreases – for example, if you pay down a credit card – your credit score will usually improve because you’ll have more unused credit available.
And you’ll have increased your available credit without dinging your score by opening new accounts. (Credit inquiries ding your score, and a sudden interest in having access to a whole lot more credit can send up red flags. Lenders may wonder why you seem desperate to borrow.)
Another reason your credit score will improve as you reduce your total debt is that you’ll be establishing a consistent, on-time payment history. Paying at least the minimum payment on or before the due date shows you are responsible, and payment history is by far the biggest single factor that impacts a credit score.
If you’ve had late payments in the past, don’t despair. Consistent on-time progress in paying down debt will help you turn things around. Plus generally speaking, the further in the past any missed payments are, the better.
Steps to take when you’re getting started
While credit reports are not the same as credit scores, getting a copy of your credit report is a good place to start. (You can get yours for free at AnnualCreditReport.com. They may ask you to purchase add-ons, but just say no to any offers and you can get your report for free.)
Review the report for any inaccuracies. If you find something that’s incorrect, you can dispute it. A successful dispute will likely help your credit score.
You will also want to get your debt accounts in good standing if you are currently behind on payments. This is because the lender reports if your account is “Current, Never Late” or “Current, Was _____ Days Late.” Having a current account means you can start reducing your debt and establish a payment history to improve your score.
If the source of your debt is a non-essential purchase like a boat or a motorcycle that you only use on the weekends, consider selling them and use the proceeds to repay the loan. Once you get out of debt, you can pay cash for the fun things that matter to you. (Trust me, it’s a whole lot easier to save up money once you’re out of debt.)
Cut your monthly expenses and/or make more income so you can focus on paying your monthly bills, making extra debt payments, and building a small emergency fund so you don’t have to borrow money unexpectedly.
Remember to budget money for fun and take advantage of free activities too so you can stick with debt reduction for the long haul. This is an awesome lifestyle change that will take you far, not a life of deprivation.
As you make progress…
You will enjoy two benefits with each loan that is paid in full. The first benefit is one less monthly payment that you need to make each month. This means less stress if you get hit with a large, unexpected bill that you would have needed to borrow money for a few months before.
A second benefit of repaying a loan in full is that your credit score might jump a few points! This is because you have lowered your total debt amount and have demonstrated that you can make consistent payments to pay your bills in full because you established a payment history.
Each on-time debt payment puts you closer to maximizing the 65% of your credit score that is determined by your payment history and amount owed. Prospective lenders primarily want to know they will get their money back. Having a low debt-to-income ratio and a consistent, on-time payment history are two of the major items they look at regarding your credit.
You might be wondering what to do once you’ve paid off an account. Conventional wisdom has it that you should never close your oldest account, but that’s a myth. I closed ALL of my accounts years ago due to divorce with no lasting ill-effects. (Closing an account will often ding your score though, and closing all my credit cards at once probably dented my score more than a little.)
The point is though, you don’t have to be held hostage by lenders, and you don’t have to carry a balance to establish a good credit history. At the very least, you can cut up the cards and not use them, or enjoy driving around in your paid-for car.
What happens to your credit score after you pay off your debt?
After you repay your debts, your credit score most likely won’t jump to a perfect score. (According to myFICO, only 1% of people have a FICO® Score 8 of 850.)
Becoming debt-free can help your score tremendously, but, until the “bad” data drops off your report over time and only the good payment history appears, your score will not be as high as it could be. So plugging away at repaying debt helps.
Extremely high scores in the excellent range are definitely possible though! The combination of debt free and good money management makes a difference. Remember your scores will vary every time they’re pulled. (Because there’s no such thing as a fixed credit score, and because there are so many different credit scores.)
A great way to improve your credit score
Paying off your existing debt is a great way to improve your credit score. Paying off debt is a whole lot better than applying for card after card and getting rejected. Or getting a new credit card and paying on time, while your old debt is still waiting to be repaid.
Debt is the 300 lb. gorilla that you need to get out of the room first. It’ll help you get ALL of your finances in better order along the way!
Many people worry unnecessarily that their score will drop like a rock once they’re done paying off debt. The trick is to continue to use credit responsibly while paying it off in full and early each month. That way you’re not carrying a balance.
Also, your credit history doesn’t disappear because you’re done with debt. The length of time you’ve had credit gets factored into your score as well, which helps.
I’ve been completely debt free since 2012 (we even paid off our mortgage early.) Here’s the score my Wells Fargo checking account showed me 5 years later:
All I’ve done since 2012 is use credit cards for purchases and then pay the entire balance before it’s due using autopay. To my way of thinking that’s no different than paying the electric bill every month before it’s due. (Which I also do through autopay.)
I don’t normally even check my credit score — I only did recently for the purposes of this article. At one time I definitely had bad credit though, because I only qualified for a sub-prime mortgage during divorce. I figured my score would take care of itself if I did financially sound and responsible things. That’s been the case for sure.
If you have bad credit…
If you have bad credit, keep one thing in mind. Responsibly repaying your debt is an excellent way to repair your credit and improve your credit score over time.
Paying off debt isn’t always the easiest task. Of course you still need money to pay your current bills and live life, but it is absolutely doable. (I know, because we paid off over $147,000. Here’s our story.) By prioritizing getting out of debt and making the monthly payments, you will soon be able to get on the right track and gradually improve your credit score.