Your debt payoff plan & how it could impact your FICO Scores
, by Kelsey
There's an endless supply of theories on how to manage your debt in a healthy, responsible way. Some people do not to get into debt at all while others rack up credit card debt after credit card debt with little consideration. Neither extreme will likely have a positive impact on your FICO® Scores, but luckily most people fall somewhere in the middle. So how do you start paying off debt?
At FICO, we recommend using available credit and loans when appropriate, making regular on-time payments, paying off debt when it's best for you and keeping your revolving debt utilization low. With that said, there are a lot of people out there that simply feel buried in debt and want to pay it off completely. That's a fine approach, but keep in mind that it might not have the impact on your FICO Scores that you were expecting.
The impact of paying off debt on FICO Scores - it's not what you'd expect
When paying off debt, remember that your FICO® Scores consider overall available credit and the types of credit you have on your reports - commonly called "credit mix." Both factors come into play when paying off debt. Let's start with available credit.
FICO Scores analyze your debt-to-credit ratio - or the ratio between the amount of credit available to you and the amount of credit you are actually using (this is also commonly called credit-to-limit ratio or credit utilization ratio). If you pay off a credit card and then close it, you'll be lowering the amount of total credit available to you. Depending on your utilization, this could lower your FICO Scores.
On the flip side, if your balances are quite high then you likely have a high debt-to-credit ratio. If you lower that ratio by paying off a credit card, it's possible for your FICO Scores to rise (but we still don't recommend closing a credit card, even if you're not using it). Learn more about credit utilization.
Now let's look at credit mix. FICO Scores consider what types of credit you have - specifically they're looking for a mixture of both revolving (e.g. credit cards) and installment (e.g. mortgages) loans. A good mixture of credit often means a consumer can responsibly manage different types of debts. So if you pay off your car completely, it's possible your scores may lower a bit because the mixture of credit has changed and is now less diverse.
Ultimately, you have to do what's best for you. If you're focusing on paying off your debt completely, that alone should be your goal. Your goal is not to raise your FICO Scores. So don't be surprised if your scores don't behave the way you'd expect. You can worry about that later - once you get your debt under control.
3 ways to pay off your debt fast
Now on to the fun part - paying off your debt. There are three common payoff methods. They all are built on the same premise: Always make the minimum required payment on all your debts, and put any extra money towards the account first on your list. Once the top one is paid off, move on to the second. The premise stays the same, but the methods behind creating your "list" (or the order in which you pay off multiple debts) vary greatly.
Smallest debt first: This method has become popular over the years, predominantly due to the popularization of Dave Ramsey and his budgeting tools and recommendations. This method asks you to list your debts from smallest to biggest. This method is great for people who need a reward or to feel a sense of accomplishment to keep momentum. If you struggle with finding the motivation to pay off your debt, this is a great place to start. You'll pay off your small debt quickly which will feel great and give you momentum as you work down the list.
The problem with this method is that it's not very efficient. If one of your largest debts has a high-interest rate, then you'll be rapidly racking up interest payments while you're focusing on paying off a small debt because it will feel good. Ultimately, this method might give you motivation and momentum, but it will likely take you longer to pay off your debt. If your interest rates vary greatly from debt to debt, then this might not be the smartest method for you.
High-interest first: This is by far the most efficient way to pay off your debt. List your debts in order of their interest rates - highest to lowest. If you look at the math, it makes the most sense. Interest rate fees are a huge part of your debts and can really rack up over time. If you ignore an account with a large interest rate, your debt will be growing exponentially while you're focusing on small debts. This method asks that you tackle the high-interest accounts first.
This method is great for people who are motivated and looking for the quickest way to pay off debt. The problem is, your debt with the highest interest could be one of your largest debts. So it could take you several months or even several years before you pay off the first item on your list. Sure, when the day finally comes it will feel fantastic, but can you keep your eye on the prize that long without getting distracted?
An emotional connection: This method is a hybrid of the two. Write down all of the debt on a piece of paper or spreadsheet, and include amount, type, interest rate and any other relevant information. Make sure all the information is right there in front of you.
Then, make two lists. The first list puts the debts in order of highest interest rate to lowest interest rate. The second list puts them in order of smallest debt to biggest debt. Look at your lists side by side. Read both lists and think about what paying off each debt would mean to you.
Now it's time to make your third list. Basically, go with your gut. With all the information now in front of you, put the debts in order of which will make you the happiest to pay off. Consider interest rates and amounts as you go, but don't be afraid to put something near the top of the list just because you really want to pay that one off. Then, voila! That third list is the one you can go by.
All three methods have pros and cons, it's a matter of deciding which one works best for you and for your personality. The most important thing is just getting started. So choose a method, write down your plan and get started! If you'd like a little help calculating a payoff date and payoff amounts, then check out this calculator.
Equal parts project manager, content marketer, social strategist and writer, Kelsey is a marketing manager at FICO and financial health enthusiast. Focused on making meaningful connections with consumers on their way to financial fitness, Kelsey is always good for a creative tip on how to keep your budget in check.