Which Debt Repayment Strategy Does the Most for Your Credit Score?

Young father working at the table while watching two young daughters.

The following is presented for informational purposes only and is not intended as legal advice or credit repair.

It's a question we hear a lot: "I want to build my credit score - which debt should I pay off first?"

Debt repayment is a marathon, after all. Most of us are always working on at least one debt, and when you're juggling multiple debts, it's smart to wonder which debt to target first. If building your credit score is your top money goal, it's helpful to understand how debt impacts your score, so you can make an informed decision on how to tackle that debt.  

Standard disclaimer to start: there’s never any guarantee that any credit-related action you take will improve your credit score by any amount. We know in a very general sense what most major credit scoring models use as a basis of their calculation, but the actual formulas used are complex and proprietary. It takes a long time and a lot of hard work to build a great credit score. 

Understand How Your Credit Score is Calculated

If you want to find the best strategy to improve your credit score, you need to begin with a basic understanding of how you've arrived at your present credit score.

Here are the major factors examined in the FICO scoring model, which is one of the more popular, widely-used models:

  • Payment history (35 percent)
  • Amount owed to all creditors (30 percent)
  • Length of credit history (15 percent)
  • Amount of new credit (10 percent)
  • Types of credit in use (10 percent)

As you can see, how much you owe is the second most important factor in your score. Assuming that you've been able to make your monthly payments consistently and haven't opened a ton of new accounts recently, simply paying down your debts is the likely the most impactful thing you can do for your credit score.

Pick a Strategy that Reduces Your Credit Utilization

Your credit score judges your “amount owed to creditors” level not as a measure of your overall debt, but as ratio of debt to available credit. If you used $5,000 of a $10,000 credit limit you would have the same credit utilization ratio (50 percent) as someone who used $500 of a $1,000 credit limit.

Generally speaking, the lower your credit utilization ratio is the better it is for your score. Most experts suggest trying to stay below 30 percent utilization, with your score likely to suffer once you go over 50 percent.

It’s important to note, however, that FICO factors credit utilization in two ways – on an account-by-account basis and as an overall reflection of your debts and limits. This means that if the utilization ratio is low on most of your cards, but one of your accounts is close to maxed out, that will likely have a negative impact on your score.

So, if you have multiple credit cards and you're trying to decide where to concentrate your repayment efforts, check the limits on each card. If you’ve got any accounts where you’re using more than 50 percent of the available limit, that may be where you want to start. If the utilization ratio is below 30 percent for all of your cards, then you may want to focus on whichever account has the highest interest rate.

Pick a Strategy that Helps You Make Consistent Payments

The number factor in almost every credit scoring model is your payment history. Simply making on-time payments every time they're due is the absolute best way to help your credit score (at least in the long run).

As such, if you're thinking about debt repayment as a way to improve your credit score, make sure that whatever strategy you choose puts you in the best position to make consistent payments.

Debt settlement, as an example, may save you money by reducing the total amount you pay, but it almost always involves missing payments to allow your accounts to become delinquent. If you're prioritizing your credit, settlement probably isn't the best choice.

On the other hand, you have an option like a debt management plan (DMP), which is created after an evaluation of your finances. The intent of a DMP is to pay off your debts quickly, but through a payment plan that fits your budget. On average, MMI DMP clients see their credit scores increase over time thanks to those consistent monthly payments, coupled with reduced credit utilization.

Does the Type of Debt Matter?

Different debts can have slightly different impacts on your credit score, and different scoring models use different rules, which can all vary pretty wildly.

The classification of the credit type matters. Only revolving credit accounts are factored into your credit utilization ratio. Installment loans are considered differently.

A regular line of credit, like a business line of credit, is usually considered to be revolving credit and would be treated exactly the same as a credit card.

A home equity line of credit (HELOC), on the other, may be considered revolving credit or an installment loan. In many cases it depends on the size of the available credit. A general rule of thumb is that a HELOC over $50,000 is usually factored as an installment loan, while anything below that is considered a revolving line of credit.

At the end of the day, while there can be a ton of factors to consider, the top priority when attempting to build your credit score should always be 1) never missing a payment, and 2) getting your credit utilization ratios as low as you can manage.

If you need help creating a plan to improve your finances, MMI offers free, confidential financial counseling. We're available 24/7, online and over the phone. If you're feeling stuck, let our experts help get you moving again.

Tagged in Build your credit score, Debt strategies

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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