You may have heard that carrying a balance on your credit cards – especially being near your credit limit – hurts your credit score. What I never realized is how much of an impact paying down that balance has on your credit.
If you need to improve your credit score quickly, there’s no better way than paying off your credit cards in full.
The first time I took my credit cards from near my credit limits to zero; my credit score jumped nearly 40 points in just one month.
This is because your debt utilization ratio is a major factor credit bureaus use to determine your creditworthiness. The debt utilization ratio is the how much of your available credit you have used. So if you have a $10,000 combined credit limit on three credit cards and a total of $7,000 in credit card debt, your utilization ratio is 70%, which would be considered high.
Obviously it’s not smart to pay off credit card debt with another loan, however there are instances when carrying a fixed-term loan is better for your credit score than a revolving account like a credit card.
Unlike credit cards, fixed-term loans like mortgages, auto-loans, and some personal loans, do not count towards your debt utilization ratio.
Instead, your credit score will reflect how many fixed-term loans you have open, and creditors will use your debt to income ratio to determine how your monthly loan payments will impact your ability to repay a new debt. (Use this calculator to figure out your debt to income ratio.)
If you only have one or two fixed-term loans, paying off credit card debt with a new fixed-term loan may actually improve your credit score.
But be careful. Unlike credit cards, the monthly payments on a fixed-term loan are higher, and there’s no minimum payment option. Also, you must be careful not to use the credit lines you have freed up on your credit cards.
If your goal is to eliminate debt all together, taking on a fixed-term loan to repay your credit card and then cutting up all of your credit cards might be a smart move.
If you do choose to keep a credit card but intend to pay it off in full each month, how much you use that credit card will still impact your credit score. Your score will look at your monthly balance before it is paid, and will not reflect the fact you pay in full each month.
Therefore, if you only have $2,000 in credit, use most of it each month but pay it off, your credit score will permanently reflect a near 100% debt utilization ratio, significantly lowering your score.