5 Things you should really consider when paying off debt
, by Kelsey
It happens to the best of us and for so many different reasons: shopping addiction, unemployed, entrepreneur, medical issues, career advancement, college. Whatever your reason, you're in debt and it's stressful.
Paying off your debt doesn't have to be a traumatic experience. With a little planning and organization, you can develop and stick to a reasonable, executable debt-management strategy. But before you start planning and making payments, make sure you understand these five key points.
- Paying off debt doesn't always raise your FICO® Scores
Many people assume that if you pay off a credit card or auto loan, you're suddenly going to see your FICO Scores raise 100 points. That's not usually the case. Your FICO Scores are generated from a complex algorithm that considers your entire credit profile. Debt is one factor — but it's not the only thing that matters. If you have other major items on your credit report, you might not see your scores change as much as you'd like.
Additionally, paying off a loan might even impact your credit mix. FICO Scores consider the different types of credit on your reports (your credit mix). Consumers who have a history of managing different types of debts, are generally considered less of a credit risk. So if you pay off an auto loan and you no longer have any installment accounts on your credit reports, then it's even possible for your FICO Scores to temporarily lower.
- Paying off your debt slowly could be better for your FICO® Scores
FICO Scores were designed to determine whether a consumer is a credit risk or not - i.e. whether the consumer will pay back his or her loans on time. One of the most consistent habits that demonstrates this ability is making regular payments for several years. This is why payment information is 35% of your FICO Scores.
Because of this factor, it's often the tortoise that wins this race. If you're able to, it might be better for you to pay off your debt quickly with just a few payments rather than pay your debt off over time. If that's better for your strategy, then by all means move forward with that plan - just don't expect your FICO Scores to increase and be prepared for them to possibly drop.
- Don't close paid off credit cards
Once you pay off a credit card (good job, you), you may consider closing the card for good so you'll never be tempted to use it again. Again, if you feel this is a required step of your debt-management strategy, then go for it. Just understand that this will likely impact your FICO Scores.
Your FICO Scores consider your credit utilization and your available credit. If you close one of your credit cards, your overall available credit amount has dropped. This can impact your FICO® Scores many ways depending on your credit profile. One of the most obvious ways is your utilization percentage. If you have debt on those other cards, you're suddenly utilizing more of your available credit - all because you closed a card. Your FICO® Scores will likely lower.
Instead of closing the card, shred it. Keep the account open but don't give yourself access to a physical card until you feel you're ready to manage your credit responsibly.
- Consolidating might be easier (not better)
It's common for consumers to feel overwhelmed by managing several different accounts and payment deadlines. An easy remedy is consolidating your debt. You can do this with a personal loan or by getting a balance transfer credit card. Then, you will only have to worry about one payment (just look out for transfer fees and high interest rates).
This can be a great way to make paying off debt easier - just don't expect it to raise your FICO® Scores. In fact, depending on your profile, your FICO Scores might not change at all. That's because the amount of debt you owe isn't actually changing. So even though it's easier for you to manage, that doesn't mean it's better for your credit health. You've essentially just moved the debt around.
- Make sure you have an emergency account to fall back on
Before starting an aggressive pay off plan, make sure you have an emergency account. There are different schools of thought of how much that should be. Some say just start with 1K, others say three months of salary. Just make sure you have some money set aside for life's unexpected expenses. Months off hard work could go down the drain if you have to put an unexpected car repair on one of your recently-paid-off credit cards. Plus if you have to completely max out a credit card, it's likely your FICO® Scores will be substantially impacted. It's better to have some money set aside to fall back on, so that nothing will derail your debt pay-off plan.
The bottom line
Create a debt payoff plan that works for your income and your financial goals, and don't worry about anything else. Although you should understand how your debt is impacting your FICO® Scores - especially if you have a lot of it - it's also important to understand that having high FICO Scores isn't the only thing that matters here. In fact, you might not see your scores go up immediately. High FICO® Scores are in general the result of responsibly managing your debt over time. So don't focus on small changes and quick fixes. Play the long game, and both your credit and financial profile will benefit in time.