It’s called prioritization! Whether you received a big tax refund, an inheritance, or a bonus, if you have recently come into a lump sum of money you may be ready to start chipping away at your debt. Of course, if you are like most people then even an unexpected influx of cash probably will not be enough to completely wipe out all the debts you owe. The question therefore becomes, which debts should you tackle first?
It is pretty much impossible to make a bad choice when it comes to paying down your debt. However, there are multiple debt elimination strategies and some are better than others. Two of the most popular debt elimination strategies include:
- Paying down debts with the highest interest rates first.
- Paying down debts which will improve your credit scores the fastest.
Option 2, paying down debts which may improve your credit scores the fastest, is a great place to start. Although paying off higher interest rate debts might seem like the best way to save money, there are actually a lot of benefits when you improve your credit scores. By paying down debts in the right order you will not only save some money on interest rates now, your improved credit scores may help you to save money repeatedly in the future.
Which Debts Should You Pay Down to Improve Your Credit Scores?
Credit scoring models like FICO and VantageScore are designed to focus on a variety of factors when it comes to debts. First, credit scoring models take a look at the type of debt you are carrying. The 2 primary categories of debts which appear credit reports are revolving debts and installment debts.
Installment debts feature a fixed payment over a fixed period of time and are typically secured by an asset. Your mortgage loan, for example, most likely requires the same payment amount each month over the life of the loan. Other common types of installment debts include auto loans, student loans, and personal loans.
When an installment debt appears on your credit reports the balance of the new account will normally have very little negative impact on your credit scores. The reason why is because installment debt, unlike credit card debt, does not generally indicate a high level of credit risk. If you were to stop paying your auto loan, for example, the bank could simply repossess your vehicle. As a result, people are less likely to default on installment loans because they don’t want to lose their cars or houses.
Since your credit scores were likely impacted very little in the first place, it is easy to understand why paying off that same installment debt in the future probably will not result in much credit score improvement. Of course, there is nothing wrong with paying off an installment loan early to save money. You just shouldn’t expect your credit scores to sky rocket whenever you do so.
By contrast, revolving debts (aka credit cards) have a big influence on your credit scores. When your credit reports show that you have tapped into a high percentage of your credit card limits, your scores are almost guaranteed to suffer. The flip side is that paying those balances down will almost certainly lead to a credit score increase. If you focus on paying down your credit card debts first you will probably receive the most bang for your buck from a credit score perspective.
It is also worth noting that you should pay off credit cards with the lowest balances first. By following this strategy, you will lower your debt-to-limit ratios and end up with zero balances on multiple accounts more quickly. Credit scoring models pay attention to both your debt-to-limit ratios and the number of accounts with balances on your credit reports. By wiping out multiple, smaller credit card debts first you may end up with higher scores because you’ve essentially killed two birds with one stone.
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