- Get Out of Debt
In an ideal world, your credit score would improve the moment you pay off your debts. Credit bureaus would be notified, credit scoring systems would account for your improved reliability, and your financial future would begin as new. But, unfortunately, it isn’t quite that straightforward.
Debt relief can devastate credit scores and, in most cases, paying off debt is just the beginning of a long and grueling process.
How Paying Off Debt Affects Your Credit Score
There are a few reasons your credit score may drop when you pay off debt, and the more balances you clear, the greater that drop will be. This is true whether you use debt relief or not, but there are a few things you can do to prevent this from happening and to lessen the impact.
Why Does Your Credit Score Drop After Paying Off Debt?
It’s possible for your credit score to drop even if you don’t have late payments and collections and there are several reasons why this may happen:
Lower Credit Utilization Ratio
Credit utilization accounts for 30% of your score. It compares your total credit limit to your total debt and the higher it is, the more your score will suffer. This ratio drops every time your debt increases or your credit limit decreases.
As an example, let’s assume that you have two credit cards. Credit card 1 has a limit of $10,000 and a debt of $5,000 and credit card 2 has a limit of $10,000 and a debt of $10,000. Your total limit is $20,000 and of this, you’re using $15,000, which means your ratio is 75%.
If you repay credit card 1, this ratio drops to 50% ($10,000 debt; $20,000 limit). If you then close that account, your ratio climbs to 100% ($10,000 debt; $10,000 limit). Paying credit card debt, therefore, is hugely beneficial, but if you close those accounts afterward then all that hard work is undone.
Applications
Every time you check your credit report it registers as a soft inquiry, which doesn’t show on your report or affect your score. Soft inquiries can also be initiated by employers.
If you follow through with an application, the creditor may initiate a hard inquiry, which does show on your credit report and can reduce your score by as much as 5 points. These inquiries are often triggered during the final stage of the application process, but they can also be triggered by credit card companies, loan providers, and even cell phone companies to determine your creditworthiness.
If you’re trying to consolidate your debt, you may need to make multiple applications to different creditors. If these applications are performed within a period of 14, 30, or 45 days (depending on the credit scoring system) it will be classed as rate shopping and all hard inquiries will merge into one. However, this doesn’t apply to credit cards, so be careful when looking for a balance transfer credit card.
New Accounts
If you open a new loan or credit card account for consolidation purposes, you’ll notice an instant effect on your credit score. There are two reasons for this.
10% of your score is calculated based on new accounts while a further 15% is based on total account age. When you acquire a new credit card or personal loan, you’ll instantly reduce the average age of all your accounts, thus decreasing this aspect of your score.
Late Payments
Some debt relief companies, including those in the debt settlement sector, will insist that you stop making payments. The more late payments you accumulate, the more likely your creditors are to settle and the more money you’ll have to negotiate with. However, while these settlements are taking place, your credit report will suffer, and it could take years to recover.
Missed payments and other derogatory marks will remain on your account for 7 years, although the damage they do to your score will lessen over time.
How Does Paying Off Debt Improve Your Credit Score?
Debt relief strategies can reduce your score in the short-term, but in the long-term, it will improve. You have less debt, more credit, and more cleared accounts—you just need to give those negative influences time to turn into positive ones (new accounts into old, etc.) and you’ll build a strong score.
If you want to avoid any negative influences on your credit report, you can repay your debts using the following tips:
- Increase your monthly payments.
- Put any extra money you have towards your debts.
- Consider the debt snowball method or the debt avalanche method.
- Refinance and negotiate with your creditors.
- Look into forgiveness programs if you have student loans.
- Consider home equity loans and credit if you have real estate.
Debt Relief That Has the Biggest Impact on Your Credit Score
Debt relief is designed to help you escape debt, avoid bankruptcy and lawsuits, and wipe your slate clean. It often does this at the expense of your credit score and the scary thing is that many debtors don’t realize the damage they’re doing until it’s too late.
By all means, utilize these services if you need them, but make sure you understand how they impact credit scores first.
Debt Management
A debt management program is like an installment loan, debt consolidation loan, and credit counseling program rolled into one. It’s a service offered to debtors suffering hardship in the form of bad credit and a high debt-to-income ratio.
Debt management is offered by credit counseling companies and credit unions. They will negotiate with your creditors and turn all your repayments into a single, manageable monthly payment. You transfer this monthly payment to the debt management company, who then distribute it to your creditors.
Debt management has many positives, but one of the biggest negatives is that debt management companies require you cancel all but one of your credit cards. This eliminates risk, but it also reduces your credit utilization score.
Debt Consolidation
Just like debt management, debt consolidation works by consolidating multiple debts into a single monthly payment. It does this via a large personal loan, one that comes with a small, manageable repayment and a reduced interest rate (although the term is typically much longer, so you’ll pay more interest throughout the lifetime of the loan).
Debt consolidation doesn’t require you to close inactive credit card accounts, but it will require you to open a new personal loan account, which will reduce your score in the short term.
Balance Transfer
A balance transfer credit card turns all your credit card debts into a single credit card balance, one that utilizes a 6 month to 18-month interest-free period. There are very few downsides to a balance transfer, especially if you keep all cleared credit cards active, but it does require you to open a new credit account and this will reduce your score slightly.
Debt Settlement
Debt settlement companies will clear your debts on your behalf, offering your creditors a settlement amount in exchange for discharging those debts. However, the process entails intentionally missing payments and allowing debts to go into collections, which can seriously reduce your score. What’s more, anything other than a “Fully Paid” status can negatively impact your credit score and multiple settled accounts can drop over 100 points from your total.
It can be very difficult to improve your credit score after debt settlement, but at least you won’t have all those debts to worry about and can start afresh.
Bankruptcy
It will come as no surprise to learn that bankruptcy can severely impact your score, much more so than debt settlement, debt management, and any other form of debt relief. The derogatory marks can remain on your accounts for up to 10 years and will have a notable effect on your score during that time. You’ll also suffer when your accounts are settled.
The good news is that bankruptcy is not the end. You can recover after a few years and return your credit to a respectable range again.
How Many Points Will You Lose?
It’s hard to predict how many points a specific action will cost you. Not only are there are two different scoring systems and multiple variations of both, but an individual with a high score will lose more points than one with a low score.
However, we can estimate point ranges based on specific negative outcomes. The following estimates are based on FICO Scores of 600 or more:
- Getting a Hard Inquiry: Between 2 and 5 points.
- Missing a Single Payment: Between 50 points and 110 points.
- Maxing out a Credit Card: Between 10 and 50 points.
- Foreclosure: Between 80 and 160 points.
- Bankruptcy: Between 120 and 240 points.
Myths about Paying Off Credit Card Debt
Education is the best form of defense against crumbling credit scores and mounting debts. The vast majority of debtors are in over their heads because they didn’t understand how damaging those store cards were going to be or how much that installment loan would impact their credit report.
Here are a few myths about credit card debt that will help to clear some of the misunderstandings and ensure you’re better prepared.
Myth: You Should Always Avoid Credit Cards
It’s true that credit cards can trap you into a cycle of debt and that they contribute to the escalating consumer debt crisis. However, credit card debt is easier to repay than many other types of debt and the cards themselves are one of the best ways to build credit.
You won’t pay any interest if you clear your balance every month and there are a multitude of rewards and cash back offers. You can secure as much as 5% cashback on every purchase you make—an offer that is practically unheard of in other developed countries. In the UK, for example, it’s very difficult to get cashback greater than 1% or 2% and the average APR is several percent higher than it is in the US.
We have things pretty good here, so take advantage of that. Credit cards only become problematic when you start spending money you don’t have and allow your balance to roll over every month.
Myth: You Should Only Have One Card
Your credit score will take a slight hit every time you sign up for a new account, be it a personal loan or a credit card. However, that hit will be temporary and if you meet your payments every month then your payment history and credit utilization will steadily improve.
If you’re a shopaholic with very little impulse control, then multiple credit cards are definitely a bad idea, but if you keep your spending under control there’s no reason why you can’t have 2 or 3.
It only really becomes a problem when you’re acquiring those additional cards because your other ones have been maxed out.
Myth: Carrying a Balance Improves your Score
The idea that you need a credit card balance to build your score is a complete fallacy. In fact, even if you repay your balance every month, it will still be treated as debt and will appear as such on your credit report.
By clearing your balance every month you’re placing a big green tick on your credit card account and moving one step closer to an Exceptional score.
Myth: You Should Keep Your Credit Limit Low
A large credit limit can be a little scary if you have a lot of debt or are concerned about acquiring it. But it can greatly improve your credit score, which in turn will improve your chances of getting low-interest loans and mortgages.
A higher credit limit means a higher credit utilization score, which accounts for 30% of your total credit score.
Myth: Minimum Payments Will Help me to Clear my Debt
In an ideal world, a $500 monthly payment on a debt of $10,000 would clear the debt in just 20 months. But with credit card debt most of what you pay is interest. In fact, the average credit card monthly payment covers just 2% of your balance and some go as low as 1.5%.
It may feel like you’re making progress, but if you only pay the minimum then it’ll take you years to clear the balance.
Every cent that you pay above this minimum will go toward the principal, so when you have the extra money, spend it. It’ll take months off your total debt term and greatly reduce the balance, which means less compounded interest.
Source: pocketyourdollars.com