One of the most frequently asked questions about credit is this:
Can I raise my credit score by paying off my debt?
The short answer is yes, but there’s a big caveat: You must keep your credit cards active.
Two of the factors that the credit-scoring bureaus consider when assigning credit scores are:
- Your balance-to-limit ratio.
- Whether your accounts are active.
Let me start with your balance-to-limit ratio. Credit-scoring bureaus award higher scores to people who have credit card balances that are no more than 30 percent of their overall limit. If your limit is $10,000, for instance, your balance should never exceed $3,000.
One of my first strategies for helping a person build a 720 credit score is to lower each credit card balance to no more than 30 percent of the credit card’s limit.
That 30 percent target is the minimum you should aim for. If you can pay your credit cards entirely, great! Your score will be higher.
Important: Many people think that if they pay their credit card balances in full each month, they don’t have to worry about having a high balance the rest of the month. This is a common misconception.
From a credit-scoring perspective, bureaus look at your credit-card balances as a snap shot in time, which means that if you have a credit card with a $2,500 limit and a $2,000 balance on the day your credit report is pulled, your score will be lower … even if you just sent in a check for $2,000 that simply has not cleared the bank.
That is why in my Webinar, I teach people to never charge more than 30 percent of their credit card balance. And the closer they can keep their balance to $0, the better!
This brings me to my second point.
You must keep your credit cards active. When I give my webinar, I explain to people learning how to build credit that they must use their credit cards. Otherwise, the credit-scoring bureaus have no way of telling whether you are a responsible borrower.
Consider it like this: Let’s say you own an airplane. Owning an airplane isn’t enough to be granted a pilot’s license. You must first demonstrate your ability to take off and land, you must have hours of flight practice under your belt, and you must hold the proper certification.
Likewise, owning credit cards is not enough to demonstrate that you know how to use them. And because credit-scoring bureaus consider the most recent activity to be the most important, you must use them regularly.
So how do you keep a low balance on your credit cards while still keeping them active?
Simple. Let’s say you have four major credit cards that you want to pay off but keep active. (Ideally, you should have between three and five major revolving credit cards.) Here is a plan that shows you how to raise your credit score by paying off your debt.
1. Identify four bills that have a set monthly payment. For instance, your gym membership, magazine subscription dues, car insurance, and health insurance bills are probably the same amount each month.
2. For each of your four credit cards, schedule an auto pay of one of these bills.
3. Then, create an auto payment from your checking account to each credit card company. This auto payment should occur two days after your credit cards are charged for the bills. Let’s say, for instance, that you create auto payments for your Visa, MasterCard, American Express, and Discover cards to pay your gym membership, magazine dues, car insurance, and health insurance bills (respectively), on the 5th of the month. You would then create another level of auto payments so that your checking account pays your credit card balances two days later.
This way, you will never pay interest, keep your credit cards active, and keep your credit cards paid off.
So what about other debt, like loans? Here’s a tip on how to build credit by getting small loans:
Let’s pretend you are going to buy some new furniture. Assume that you have enough money to buy the furniture outright; however, you would like to build your credit.
If the bank will report the loan as an “Installment Loan” to all three credit bureaus, it’s a great idea to finance part of the purchase. Then, pay the bills for three months before paying the remaining balance in full.
Let’s assume you finance $5,000 and pay 10 percent as an interest rate. Your monthly payments are $41.66, and you pay these for three months before paying the balance in full. During these three months, you pay only a little bit in interest, but you have a new item on your credit report that appears as “Paid in Full” and “In Good Standing.”
If you have any other questions about credit, be sure to post them below.
Make it a great day,