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Whenever you come across a bonus or any other lump sum payout, there comes the sweet dilemma. ‘Do I save it or pay off some debt?’. Both options are important and require some consideration before making a decision.
Investing offers you peace of mind that you will have assets at your fingertips to maintain a stable financial state in the future. It might help you achieve a few necessary financial milestones like retirement, company ventures, and compensation for a child's college education, etc.
But paying off an existing debt or at least a part of it can reduce the interest burden and place more funds in your hands every month. However, if you have home loans, you have to consider the tax benefit you are getting on the interest payments before paying it off.
However, when you have no outstanding debt or revolving credit, your credit score might be affected. It is important to pay your credit card bills on time but also to use your credit card regularly to have a good credit score. Therefore, one has to strike a good balance between their credit card usage and the total outstanding on their credit cards to achieve a healthy credit score. Then there are loans like your student loan, car loan or personal loan that are contributing towards your credit score by creating your repayment history.
To understand the effects of repaying your debts on your credit score, let us first understand what goes into making your credit score.
What Are The Factors That Make Your Credit Score?
Many variables, such as whether you pay bills on time and the length of time you used a credit, how much of your credit limit are you spending every month, what is the tenure on that car loan and similar factors decide your credit scores. Understanding the factors that affect credit scores helps you work the most efficient way of building or protecting your credit. Here is a rundown of the variables in the order of importance that impact your credit scores:
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Payment history
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Credit utilization
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Length of credit history
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Mix of credit types
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Recent applications
Now there are various types of debts one has to manage. They might have credit cards, car loans, student loans or home loans. From the above list, Payment History is the foremost factor affecting your credit score and one has to make sure that they have a healthy repayment history to maintain a high credit score.
Another factor deciding your credit score is the Credit Utilization part. Credit utilization basically points to the amount of revolving credit you have on your credit cards and shows how well you manage your debt. Indeed, with your credit utilization ratio, paying off debt can greatly improve your credit. The lower your revolving debt, the better your ratio of credit utilization. And the better your ratio of credit utilization, the better will be your credit score.
Though a low credit utilization ratio is good for your credit score, zero credit utilization ratio can harm your credit score.
How Closed Accounts Affect Your Credit Score
You might think closing an account could automatically remove a credit card or other account from your credit report. But while you can't use it after closing an account, that doesn't mean it's gone out of your credit history.
According to Equifax, closed accounts with negative remarks such as late or missed payments, collections and charge-offs will remain on your credit report for about seven years. On the other hand, closed accounts with a "pay as agreed" status can remain on your credit report for up to 10 years from the date it was reported as closed by the lender. So, whether it's a loan or a credit card, your score may still be affected by a closed account.
With a credit card, closing an account causes you to lose the credit you get on that card which will increase your credit utilization ratio and ultimately affect your credit score.
Loans are a bit different as they contribute towards your revolving credit quotient and don’t have much effect on the credit utilization ratio. Once you pay them off, the account is closed. However, this might have an effect on your payment history.
So, Should I Pay Off My Debts Completely Or Not?
Coming back to the big question, should you pay off your debt completely? Yes & No.
It is prudent to pay off loans, as they have lower impact on your credit score. But it is wise to not close all your credit cards as your credit limit contributes towards a good credit utilization ratio. Here are some good practices to follow to maintain a healthy credit score
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Pay your bills on time. This helps in creating a healthy repayment history. Make a debt management plan and diligently put away money towards debt payments every month.
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Keep credit cards open unless you have a very good reason to close them, like high annual charges, bad customer service, etc. Remember, closing a credit card account can affect your available credit and the average account age. If you don’t want to use a card, just make minimal charges on it to keep it running.
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Do not apply for new credit unless necessary. Just don’t get that new Platinum Chip card yet. Manage your current credit wisely to build your credit score. Ask for interest rate reduction, nil annual charges and other benefits from your current credit card company. You would be surprised to know the benefits you can get just by asking.
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Go for balance transfer of your loans. When you balance transfer your loans to a new lender, you will end up with lower interest rates and other attractive offers that will help you to manage your debt better.
End note: Striking a balance between your debts and credit score requires conscientious planning and execution. Though you might feel relieved by paying off all debts, maintaining a healthy credit score is necessary for your future credit needs. So, pay off debts that are costing you a lot in interest and manage the ones with low outstanding. Make sure you have a healthy revolving credit through sensible use of your credit cards. Student loans, car loans and personal loans can be paid off or you can opt for balance transfers on them to reduce the payouts on them. Ultimately, good debt management means high credit score and zero debt means low credit score