Debt is like weight gain. To many people, an extra treat here and a little splurge there don't seem like real problems.
Over time, though, the bits and pieces add up and one day they wake up and say, "How'd that get there?"
The good news is that it's never 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 in both goals at the same time.
Below are answers to the most common debt and credit questions, from expert tips to what debt to pay off first to raise a credit score.
Large debts and poor credit often go hand in hand. That's why it's great to know that working toward one goal will help with the other one as well.
One of the many factors that impact a credit score is the person's credit utilization ratio. This is the percentage of revolving credit that they're using.
Revolving credit is any credit a person can use over and over like credit cards. If a credit card has a $10,000 limit, someone can use the credit, pay it off, then use it again.
It's different from a car loan, for instance. 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's easy for people to calculate their own credit utilization ratio.
First, they need to add up the credit limits for all their credit cards. Next, they add up the balances on all those cards. When they divide the balance total by the credit limit, that's their credit utilization percentage.
The goal should be to get a utilization ratio below 30%. However, the lower the better. Every dollar of revolving credit a person pays off will improve their utilization ratio.
Another important part of a person's credit score is their payment record. The reason people have poor credit when they first turn 18 is that lenders have no record to tell them if the teen will pay their bills on time.
Let's say it takes someone two years to pay off their debt. That's two additional years of reliable payments on their record, which will improve the credit score.
In truth, this doesn't affect a person's credit score directly. However, one of the most common reasons people strive to pay off debt and raise their credit score is that they're trying to buy a home. Their debt-to-income ratio plays a large role in their mortgage qualification.
As one would expect, a debt-to-income ratio calculates the percentage of a person's monthly income that must go toward debt. It's based on their minimum payments, not the amount they choose to pay.
With certain debts like credit card debt, the minimum payment goes down as the balance goes down. The result is a better debt-to-income ratio.
It's clear that paying off debt improves a person's credit score in several ways. For most people, though, their debt involves several types of accounts. Here's how to prioritize.
A credit score doesn't just look at how much debt a person has but at the types of debt they have too. They can categorize the accounts into "good debt" and "bad debt."
Good debt includes a mortgage and student loans. Investing in a home or a degree can improve a person's financial situation in the future, making it possible for these debts to be productive.
Bad debt, on the other hand, doesn't have the ability to improve the person's financial situation. That includes credit card debt and personal loans. To boost their credit score, a person should focus on bad debt before good debt.
For someone who's trying to pay off their debt in a way that helps their credit score the most, they should keep their utilization ratio in mind. It's best to pay off their revolving credit before other debts.
For instance, if someone has credit card debt as well as a car loan, they should pay off their credit card debt first.
Even when people know which debts to pay off first, it can be hard to figure out the next steps. These tips can help.
As mentioned above, it's important to pay off credit card debt first. For people with multiple credit cards that have balances, though, they should focus on the one with the highest interest rate first.
If all the 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 will lower their largest monthly interest charges from the start.
In general, it's better to pay off larger and more interest-heavy debts first. For some people, though, it's discouraging that it will take so long to cross one debt off their list.
Those who need some extra motivation can start with the snowball method instead.
In this method, they keep making minimum payments on all their accounts but they put extra money toward their smallest debt. It's easier to see progress and stay motivated this way.
There's a common trick for paying off high-interest credit card debt. It involves applying for and receiving a new credit card that has a 0% introductory interest rate. The person transfers their debt to that card so they don't pay interest while they're paying it off.
That tactic is great if paying off debt is the only priority. However, it can hurt the person's credit score in the process. For one, adding a new credit card lowers the average age of their accounts, which can hurt their credit score.
It's also common for people who do this to close the credit card that had the original debt. If they do this, it will likely hurt their credit utilization ratio because chances are that the new card will have a lower credit limit.
Paying off debt and increasing a credit score doesn't just require money. It also requires some research, like knowing what debt to pay off first to raise a credit score. The tips above can help anyone tackle their financial goals in no time.
For a more hands-on approach to credit improvement, our credit repair experts can help.
John McConnell is a nationally recognized Credit Expert and Specialist in Personal Finance. Currently, John's work is focused on editing and providing informative and entertaining presentations about personal finance. He also provides consultation to the private and public sectors on issues involving all aspects of credit repair, crediting, lending, and information security.