The Truth About Paying Off Credit Cards and Your Credit Score

how does paying off credit cards affect credit scoreIt seems like it wasn’t long ago when no one cared about your credit score.

Now I feel like it affects you in almost everything you do.

The one thing I despise about credit scores is that trying to understand how they are really calculated is like trying to solve a calculus problem in a foreign language.

Impossible.

Thankfully there are people like Phil Tirone from 720Creditscore.com to save the day.  :)

A question that I’ve already received from a few Debt Movement participants is:  “How does paying off my credit cards affect my credit score?.  Instead of pretending to know the answer, I instead enlisted Phil to answer the question for you.   Enter Phil……

******

If you want to know how to raise your credit score by paying off debt, you should know two things:

  1. The lower your balance-to-limit ratio, the better your score.
  2. You must keep credit cards 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.

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.

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? 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.”

In summary, if you want to know how to raise your credit score by paying off debt, remember two things: keep your balance low and keep your debt active.

Philip X. Tirone is the creator of The Free Credit Score Webinar and the 14-Day Credit Challenge, both of which teach consumers how to raise your credit score and achieve a 720 credit score. You can visit his blog on how to raise your credit score at 720CreditScore.com.

  • http://www.insiderrealestatetips.com/ Dominique Brown

    Great Advice.. However, getting a small loan definitely will make your credit score drop. Why? Well you will be cutting your credit length and getting hit with a hard inquiry. I think the article should be updated to reflect the drop in the credit score that will occur. Also, credit cards that aren’t actively used still weigh positively on your credit report. I know this b/c I have 16+ credit cards open and only use 1 and the CFPB just released a report on credit cards that specified that credit cards carry the most weight on your credit score. With that said.. the part on using a credit card for auto paying a bill like a cellphone is excellent for people who want to build credit, but have spending problems. One could auto pay the cell phone bill via the credit card and then auto pay the credit card from a checking account.