Credit scores are the report cards of the adult world. The better your score, the better interest rates you’ll be able to lock in when taking out loans and the more likely you are to be approved for new lines of credit. Credit scores generally range from 300 – 850, with anything over 700 considered a good score.
How debt relates to your credit score
While many factors are taken into account when calculating your credit score, your credit utilization accounts for approximately 30% of your score. Your credit utilization is how much debt you have compared to how much credit you have. For example, if you have a credit card with a limit of $1000 and you have $300 worth of credit card debt, you will have utilized 30% of your credit. Ideally, you want to keep your credit utilization below 10%.
See how your credit score compares to Credit Sesame members.
There are two ways to lower your credit utilization. The first is to pay off debt to bring your debt to credit ratio down and the second is to increase the amount of credit available to you. If you currently have a high debt to credit ratio, you might have difficulty raising your credit limit. So you are more likely to start seeing success in raising your credit score by paying down debt.
Debt pay-off strategies
To get the most bang for your buck, you will want to pay off debt strategically. There are several different strategies you can use to pay off debt, including a debt avalanche, debt snowball, and the snowflake method. Which of the strategies you’ll use will depend on how you are best able to stay motivated to pay off debt. Under each of these strategies, you continue to make the required minimum payment to each of your debts and then target extra payments towards one particular debt.
Using the debt avalanche method, you list your debts in order of interest rate with the highest interest rate first. After making all the minimum payments, you would put any extra money towards the debt with the highest interest rate. You keep putting all extra money towards that debt until it is paid off.
Over the long term, this method will save you the most regarding paying interest. However, some may struggle with staying motivated because of how long it may take to get that first debt paid off.
The debt snowball method has you order your debt by balance amount with the smallest debt listed first. You continue to make minimum payments on all your debt but target extra money to the smallest debt until it is paid off. Then all the money you were applying to the smallest debt gets rolled into the payment of the next smallest debt. Slowly snowballing your payment until you are making large payments towards your largest debt.
This strategy tends to have a quicker emotional payoff because you can pay off that first debt quickly which keeps you motivated to pay off the next debt. Whether you prefer the debt avalanche or debt snowball depends on how you are best motivated to continue paying off debt.
The snowflake method can be used in conjunction with either the debt avalanche or debt snowball. The snowflake method has you applying any extra money you have as soon as you have it directly towards your debt. For example, if you get a $5 rebate it goes towards your debt immediately. Found a dollar on the ground? It goes towards your debt. The idea being that all those small amounts over the course of the month add up to make a significant difference on your debt balance.
Applying the extra money towards the debt as soon as you have that money is key. If you hold onto that money with the intention of applying it towards your debt later as one big payment, you will likely find yourself spending that money on other things.
Debt and Interest Rates
If today your debt balance is $1,000 and you plan to pay it off in 3 months, you will end up paying more than $1,000. Reason being that you will have to pay interest on that debt. Interest is how lenders make a profit from lending you money.
How your interest rate is determined can depend on several things including your credit score and the type of credit. For example, credit cards tend to have higher interest rates than car loans.
Understanding your interest rate and how it is calculated daily
There are two types of interest, simple interest, and compound interest. Simple interest is based solely on your principal balance. Compound interest means you are charged interest on both your principal and accrued interest.
Debt with compound interest costs you more to pay back. Consumer debt such as credit cards typically charges you compound interest. You’ll also want to find out how often interest is calculated and applied; it could be daily, weekly, monthly or yearly.
As an example, a $1,000 balance with a 12% interest rates compounded daily would charge you $0.32 in interest on day one and by day 14 would be charging you $0.34 in interest per day as it charges interest on the balance of both the principal and interest combined.
How minimum payments are applied
Minimum payments are applied first towards interest and then towards the principal. By law, your minimum payment must be high enough that it does pay off some of the principal balance. So if you incurred no more debt, you could eventually pay off the debt in what is a reasonable amount of time. One of the only exceptions to this law is student loan debt being repaid under income-driven repayment plans.
The difference between refinancing and consolidation
Depending on your current financial situation, refinancing or consolidating your debt may save you money in the long term. Refinancing means taking out another loan at a lower interest that is used to pay off the previous loan. You are then paying back the same amount of debt but at a lower interest rate. Refinancing is essentially just trading one loan for another.
Loan consolidation involves combining multiple loans into one loan with one payment. The interest rate on the consolidation loan depends on the types of loans you are consolidating. For federal student loans, the interest is the weighted average of the interest rates of the loans combined. However, private consolidation loans will have different rates for consolidation loans depending on if you choose a fixed or varied interest rate, how good of a credit score you have, and the length of the repayment term you choose. Consolidation is trading several loans in for one big loan.
How federal student loans, private student loans, and consumer debt compare in repayment
As has already been noted, there are some differences regarding repayment of federal student loans, private student loans, and consumer debt such as credit card debt. Accordingly, how you tackle that repayment and apply different debt repayment strategies will vary. You may choose to implement the avalanche method separately for each type of debt you have and then prioritizing the types of debt over one another.
What is consumer debt?
Consumer debt is typically considered any debt that is for personal purposes. However, regarding your credit score consumer debt is often referring to revolving debt such as credit cards and home equity lines of credit. Installment debt such as student loans or car loans that are well managed will not have as significant of an impact on your credit score so long as you remain up-to-date on your payments and make all your payments on time.
Federal student loans vs. private student loans and the difference in repayment
Besides who is lending the money to you the biggest difference between private student loans and federal student loans are the repayment plans available.
Due to the financial burden of high balance student loan debt, federal student loan borrowers have several different flexible repayment plans available. These include income-driven repayment plans, graduated repayment, extended repayment, and public service loan forgiveness in addition to the traditional standard repayment. Federal loans also have some flexibility regarding when a loan is considered to be in default, giving borrowers a chance to prevent default for nine months.
Private student loans, on the other hand, are deemed to be in default as soon as you miss a payment. Defaulting on a loan can have a significant negative impact on your credit score. Additionally, private student loan lenders don’t typically have nearly as many options when it comes to repayment plans. The limitations with private loans are why it is important to consider what you may be giving up by refinancing a federal student loan with a private loan.
How to pay off debt faster
Even with the debt strategies discussed above, there are a few other things you can do to get your debt paid off faster, thus improving your credit score faster.
Make multiple payments each month
Similar to the snowflake method discussed above, but where the snowflake method is meant to increase how much you put towards your debt, even just splitting the minimum payment into two payments over the course of the month can help. By dividing the minimum payment (ensuring you’ve paid the entire minimum payment by the due date), you will be paying less interest overall.
This is especially so for debt with compound interest since payments are applied to interest first the more interest and balance you pay off with a partial payment, the less interest you will pay over the course of the month.
For example, if you have a car loan with a balance of $10,000 with an interest of 4.5% and a minimum payment of $258, the first half payment would be $129 made 14 days after the last payment. That first payment would end up paying off about $17.26 of interest and $111.74 of the principal. Meaning the second half of the payment made 14 days later would pay $17.06 of interest and $111.93 of the principal balance. Saving you $0.20, which may not seem like much but over time it can add up.
Ensure extra payments are applied to the principle first
While the minimum payment is required to go towards paying off interest first, you can direct any additional payment you make to be applied towards the principal first. The lower the principal, the less interest is accruing.
Some lenders allow you to direct the money this way when you make the extra payment online. Others require you to call in to make the payment and have it applied to the principal first. Reach out to your lender and ask if you are unsure of how to make sure extra payments are applied to the principal first.
Consider refinancing or consolidation
As mentioned above consolidation and refinancing can help you save money on the amount of interest you pay. The less interest you have to pay, the more principal you can pay with the same monthly payment. This will allow you to finish paying off your debt faster.
Other ways to improve your credit score
While paying off debt is likely the easiest way for you start taking action to raise your credit score quickly, there are other things you can do to ensure your credit score improves.
Ask for an increased credit limit
Once you start paying off debt and lowering your overall credit to debt ratio (credit utilization), it will be easier to ask for and receive a credit limit increase. You may even find that your lenders raise your credit limit automatically as you pay off your debt.
If the raised credit limit is not automatic and you submit a request for an increased credit limit, be prepared to have a hard check on your credit score which can temporarily lower your credit score by a few points. However, the raised credit limit and resulting drop in credit utilization will have a bigger impact on your credit score.
The potential of a lower credit utilization will increase your credit score several points, more than making up for the few points in may drop because of the check. When requesting a credit limit increase, you may also be asked to provide proof of income, if you are making more money than previously reported to them, they are more likely to approve a credit line increase.
Always make on time payments
While your credit utilization accounts for 30% of your credit score, making on-time payments accounts for 35% of your credit score. Try always to make sure you have submitted the minimum payment on time for all your bills, not just debt payments. This means that you pay your utilities and your rent on time as well as all those subscription services. Fortunately, even if you are few days late with a payment, most creditors don’t report late payments unless they are at least 30 days overdue.
Don’t invite lots of hard checks on your credit at once
Having lots of hard checks on your credit can lower your score. So while it might seem like a good idea to apply for lots of credit to decrease your credit utilization, doing a bunch of these at once will have a negative impact. Hard credit checks affect your credit score for 12 months. You don’t want more than a handful of hard checks on your credit each year, and ideally, it won’t be more than 1-2.
It’s is important to note that looking up your credit score can be done using a soft check that does not impact your credit score.
The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.