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Ask the Expert: Do You Have to Have Debt In Order to Have a Good FICO Score?

(Image Courtesy of Emilio Labrador, Flickr) 

We asked our Facebook fans and Twitter followers to share their most pressing personal finance questions. Now, John Ulzheimer, credit expert and Credit Sesame blogger, weighs-in.

Q: I’ve tried hard to pay off debt. Now I have a couple of credit cards with zero balances, a car loan and a mortgage. I applied for a new car loan and was told my credit was too thin to qualify for the best rates! Why did my credit score drop after paying off debt and what’s the magic way to have great credit but not carry balances?

John Ulzheimer: This is a great question and a very common struggle for people with young credit.  For sake of clarity, you’ll notice that I wrote “young credit,” not “young people.” Credit scoring systems don’t care how old you are, despite the fact that it’s perfectly legal to consider your age when calculating a free credit score. Credit scoring systems do, however, care how old your credit reports are.

I want to take a moment and focus on the last part of this question, where our reader asks how to improve credit score without carrying balances. This question underscores a significant myth about credit scoring systems, which is that you have to have debt in order to have the best FICO scores. Some well-known financial experts say that FICO scores are a product of consumers’ love of debt. Unfortunately, that’s just not accurate.

To really understand why this line of thinking is flawed, we need to consider two things:

  1. Thirty percent of the points in your FICO score are directly tied to your amounts and types of debt. That means that 70 percent of the points in your FICO score have nothing to do with whether or not you carry debt or have balances on your accounts.
  1. Within that thirty-percentage category, you are penalized for carrying balances, having too many accounts with balances, and for having credit card balances that are too close to your credit limits. Meaning: You are not rewarded for having debt. Conversely, you are heavily rewarded for having little or no debt and for credit card balances that are low relative to your credit limits.

The truth is you don’t have to have debt in order to have a great FICO score. According to FICO, the people with the highest FICO scores (760 and above) have credit card balances that represent a mere seven percent of their credit limits. That’s a $700 balance on a $10,000 credit card.

If you want to buy a home or are considering the best time to buy a car, you’re going to need access to capital through financing. That means you’ll need impressive credit reports and credit scores. This is the only way lenders will know you are credit worthy. But having a solid credit history isn’t the same as having debt, in any amount.

Now, back to the Facebook question at hand. One of the best things you can do to ensure you’re getting the best rates possible is to comparison shop, especially for an auto loan where there are normally dozens of local lenders who will compete for your business. This is the best way to pay off debt and raise credit score.

Credit industry standard says a “thin” credit report is typically one with just one to three accounts present. In this case, our reader identified at least four accounts (a mortgage, an existing car loan, and a few paid-off credit cards). That isn’t a “thin” credit report. My conclusion is that this auto lender may be slightly less sophisticated than others so go shop around! Talk to other lenders and ask them for a quote. It may be more effort, but you’ll be happier in the long run with a lower monthly payment.

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4 responses to “Ask the Expert: Do You Have to Have Debt In Order to Have a Good FICO Score?”

  1. Laura Rodriguez says:

    Just how long after paying off debt credit score increase can I expect? I need to buy car for work. Help!

    • Samson L says:

      After paying off credit card debt credit score should increase within one month. It takes time for the bank/lender to notify the credit bureau and then the credit bureau only updates the scores once a month. So be patient!

  2. Burgeeta says:

    I would like to know does student loan debt affect your credit score? My son is about to head off to college but he will need to take out student loans. With everything going on in the news lately I don’t feel good about him taking on debt before getting a job. What if my husband and I make the payments on his student loans each month…
    will paying off all debt raise credit score instead of hurting it? Thanks so much.

  3. J. Johnson says:

    I understand that after paying off debt credit score should improve. But how long will it take? If i pay off debt will my credit score improve within the next month? Or will it take longer than that. I get that the credit bureau will have to update my report, but even once that is done will the changes be reflected in my score immediately or does it happen slowly over time?

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