A frustrating credit myth which stubbornly refuses to die is the false idea that you have to go into debt (get a credit card, plus auto loans, plus a mortgage) in order to build good credit scores. The truth, however, is actually quite the opposite, regardless of the advice you may have read in that new post which showed up in your favorite online newsfeed. Paying down and ultimately eliminating your debt is the real action which will benefit your credit scores the most significantly.
Yet simply deciding to pay down your debt indiscriminately in order to potentially benefit your credit scores is not the best course of action to follow either. Before you rush out and write a big check to knock out your debts you need to understand that when it comes to your credit scores all debt is not weighed equally. Some types of debt will hurt your credit more than others when it shows up on your credit reports in the first place. By extension, paying down the more credit-score-damaging types of debt will have a better impact upon your credit scores than paying down less credit-score-damaging debt.
What about Auto Loans?
Auto loans, like mortgages and personal loans, are referred to as installment debt. Credit scoring models treat your installment debt very differently than they treat your credit card (aka revolving) debt. Installment debt is generally low risk debt which is often secured by an asset. Therefore installment debt is not considered as heavily by credit scoring models. Balances can certainly matter in the calculation of your credit scores, but even installment debt with high balances tends to have very little negative score impact.
As a result of the low impact which installment debt has upon your credit scores in the first place, paying off an installment loan early typically will not net you much improvement in the credit score department. It may certainly save you money in interest fees to pay off an auto loan early (depending upon your loan terms and conditions), but that auto loan pay off probably will do little to nothing to boost your credit scores.
What about Revolving Debt?
Credit card debt is another story entirely from a credit scoring perspective. If you want to get the biggest credit score benefit possible by paying down debt then you should definitely start by making a plan to tackle your revolving debt first. Before paying off any auto loans, destroy the credit card debt!
High risk credit card debt will generally have a negative impact upon your credit scores and the higher the amount of the credit card debt you carry the worse that impact will be. FICO’s credit scoring models are designed so that 30% of your credit scores are largely based upon your credit card debt or, more specifically, your credit card debt to limit ratios.
As you charge up more of your credit card balances with respect to your account limits your credit scores will progressively decline. For this reason when you finally begin to pay down that outstanding credit card debt the positive credit score impact you see will be much more significant.
Believe it or not, you would almost certainly see your credit scores increase much more by paying down a $500 credit card balance (on an account with a $500 limit) than you would see if you were to pay off a $25,000 auto loan balance. If you have extra money and are looking to eliminate debt in a way that will benefit your credit scores then paying down your credit card debt is going to be the most effective use of your resources every time. Don’t worry about your auto loans (or any other installment debt) before eliminating that credit card debt!