We all know how paying your debts on time and correcting credit errors can improve your credit score. But you can also improve your credit score by reducing your debt.
Credit scoring models consider credit utilization to be the second most important factor in determining your credit score. It represents 30% of your credit score, while paying your bills on time is 35%. That is to say that credit utilization is almost as important as paying your bills on time!
Credit utilization represents the amount of outstanding debt you have compared to the amount of credit you have available. For example, if you have $20,000 in available lines of credit, and you owe $8,000 on them, your credit utilization ratio is 40% ($8,000 divided by $20,000).
A credit utilization ratio of 30% or less is a strong positive in calculating your credit score. A credit utilization ratio above 80% is a strong negative, because it indicates that you’re reaching a point of being “maxed out” on your credit.
Apart from paying your bills on time, the next best thing you can do is to reduce your debt. That will lower your credit utilization, which will improve your credit score.
Here are five ways to reduce your debt and improve your credit score.
1. Payoff Any Past Due Balances You Owe
This is one of the fastest ways to improve your credit score, at least a little bit. Past due balances weigh heavily on your credit score. By paying them off, you can jumpstart your credit score quickly. While paying off very small past-due balances may not have much of a positive effect, paying off a larger balance, or several smaller ones, can jump your score by 20 or 30 points. If you’re applying for a loan, that may be all the improvement that you need in your score.
It’s sometimes possible to negotiate a lower settlement on past-due balances, particularly if the delinquency is pretty old (more than two years). The creditor may be anxious to settle the account, and be willing to accept substantially less than the original amount due.
If you do attempt to negotiate a lower payoff, be sure that you get the terms of the settlement in writing before sending any money. You want to be sure that the creditor fully plans to accept the lower amount in full settlement of the account. Confirmation should be provided in writing, spelling out the exact details of the settlement.
If it is a fairly large settlement, you may want to enlist the help of an attorney who works specifically with credit problems. There may be legal and/or tax considerations in your particular state, as well as the possibility that the creditor may include language in your credit report such as “settled for less than the full amount due”, which won’t have as much of a positive impact on your credit score as if they were to simply report it as “paid account”. An attorney will know how to make that happen.
Important Notes: One tactic some borrowers use is to tap into peer-to-peer lending companies. Not only might the rate they offer be lower, but as of now, those loans don’t show up on your credit report as long as you make your payments. That brings down your credit utilization and should help bump up your score.
2. Pay Down Credit Card Balances
If you owe substantially more than 30% of your available revolving credit, paying these lines down is one of the best strategies to improve your credit score.
You don’t necessarily have to drop your credit utilization all the way down to 30%. If you’re currently at 70%, dropping it down to 50% can provide a noticeable improvement in your credit score.
For example, if you have $20,000 in available revolving credit, and owe 70% – $14,000 – you can improve your credit score significantly by dropping your credit utilization down to 50%, or $10,000. This would involve paying off $4,000 in revolving debt, rather than trying to pay off your entire credit card balance at one time.
3. Payoff Your Smallest Debts
Another aspect of credit utilization that we haven’t discussed yet is the number of accounts with open and active balances. Beyond a certain point, it is possible to have too many accounts with balances on them. However, even a relatively small number of open accounts can be problematic if every one of them has a balance due on it.
One of the best ways to improve your credit score is to eliminate your smallest debts. For example, if you have eight current available credit lines, and seven of them have balances on them, you could improve your credit score by paying off the two smallest accounts. That would reduce the number of accounts with open balances from seven down to five.
The fact that you have unused credit accounts is an indication that you are in better control your finances. Much like maxing out credit cards, maintaining too many accounts with balances is seen as a negative for credit scoring purposes.
4. Paydown an Installment Loan
If you recently opened an installment loan, such as a new auto loan, this will have a negative impact on your credit score. The reason this is true is because there is a lack of history on the account, so whether or not you can actually manage the new payment is something of an open question.
This is normally solved by time. For example, if you are one year into a five-year-old loan, it will have a better effect on your credit score than if you just opened the loan last month.
But you may be able accomplish something similar by paying down the loan. For example, if the initial balance of the loan was $20,000, paying the loan down by $4,000 – or roughly one year’s worth of principal payments – can reduce the risk on that loan, and increase your credit score.
It’s not quite the same thing as a 12 month payment history, but the reduction in balance will still have a positive effect on credit score.
5. Take Out a New Credit Line But Don’t Use It
This strategy doesn’t actually reduce your debt, but it can have a similar effect, at least as far your credit score is concerned. If credit utilization is a problem – if your credit utilization ratio is well beyond 30% – one way you can improve this without paying down your credit lines is to take out a new credit line, but not use it.
The new credit line will increase the amount of credit you have available. For example, if you currently have $20,000 in available credit, and over $14,000 borrowed on those credit lines, your credit utilization is 70%. But if you add a new credit line for $10,000, your available credit instantly increases to $30,000. The fact that you still owe only $14,000 means that your credit utilization ratio will immediately drop below 50%. That should increase your credit score.
One caveat here is if you have difficulty keeping yourself from using available credit lines. Though the new credit line will improve your credit score in the short run, taking draws and making purchases against the new line will ultimately increase your debt, as well as your credit utilization ratio. At that point you’ll be in a worse situation than you were originally because you will owe even more money.
Use this tactic only if you are sure you have the self-discipline to not use the new credit line.
If your credit situation has already reached the point of being uncomfortable and difficult to manage, get credit help. Credit problems tend to feed on themselves and only get worse with time. Take action while you’re still in control of your situation.