Determining which debt is best to pay off first to raise your credit score depends on the motivation.
A higher credit score can reduce your insurance premiums, and make it easier to qualify for new borrowing accounts with better terms. However, your debt-to-income ratio (DTI) and down payment amount are also critical factors with lenders but not insurers.
Therefore, think carefully about how to allocate scarce resources.
Returning a delinquent or collection account to the current status is always the top priority, as payment history is the most critical factor regardless of your goals.
Then, paying off revolving debt is best for improving credit scores, while retiring installment obligations can also help your DTI – but sometimes at the expense of your deposit.
Paying off Revolving Debt First
Consumers should prioritize paying off revolving debt first when their motivation is an improved credit score that lowers auto and homeowner insurance premiums. Insurance companies see excessive claims risk with people teetering on the edge of delinquency, as expressed by the revolving utilization ratio.
Utilization Ratio = Revolving Balances/Account Limit
The utilization ratio improves when you pay down the balance (numerator) because the revolving account remains open, keeping the limit (denominator) in the fraction constant.
Individuals should pay off revolving credit card debt first to raise credit scores because the equations are most sensitive to unsecured obligations of this type.
- Revolving balances often soar to the peak of the account limit when consumers begin having financial trouble
- Lenders cannot repossess collateral in the event of default, so people often allow these accounts to become delinquent before any others
Think of the utilization ratio for unsecured credit cards as an early warning signal of future default. Therefore, you want to drive the percentage down by lowering the total balances while maintaining the account limits.
- Banks report the balance at the end of the billing cycle, which could still be a significant number even if you pay the full amount owed each month
- Credit limits remain the same provided you do not close the account, and the bank does not lower the threshold due to inactivity
Consumers probably should not prioritize paying down a revolving Home Equity Line of Credit (HELOC) to improve credit scores unless their utilization ratio is very high (above 70%). Your house acts as the collateral in this secured contract, and people are reluctant to lose their place of residence via default.
Therefore, the equations are less sensitive to this obligation type, and shrinking the balances earns fewer points. Plus, the interest rates on a HELOC are much better because of the security.
Paying off Installment Debt First
Individuals should highlight paying off installment debt with small balances first to raise their credit score when they plan to buy a new car or house. The reason is that auto and mortgage lenders weigh your DTI ratio heavily when making these underwriting decisions, and you do not want to reduce your down payment by too much.
Retiring at least one installment loan is the best way to improve your DTI ratio because the monthly payments cease when the account closes, and the balances cannot grow back. However, the impact on your credit score could be less impactful for two possible reasons.
- Balances decline over time by design so moving to zero helps less
- Account diversity could weaken if you close the only loan of its type
Paying off student loans is often the best way to improve your credit score when financing a new car or taking out a mortgage to buy a house. Four-year college graduates can have up to sixteen separate installment accounts if they borrowed money each semester through the federal government and private lenders – and did not consolidate.
Whether you have eight or sixteen student loans or any number above one, the separate account structure offers three enormous advantages.
- Retiring one of eight accounts lowers your DTI by 12.5% on average even if it has the lowest balance because the ratio looks at the monthly payment, not the amount outstanding
- Paying off one contract when you still have many others open does not affect your account diversity much, thus minimizing any negative impact on your rating
- Retiring the smallest balance allows you to allocate remaining resources towards a down payment
Paying off car loans first to improve your credit score makes sense only when you are near the end of the term. By design, the balances of these installment contracts shrink closer to zero as time marches on.
Therefore, retiring an auto loan with a small balance could be an excellent way to optimize the allocation of any extra cash before buying a house.
- Plus: the typically high monthly payment can have enormous sway over your back-end mortgage DTI qualifier
- Minus: you diminish the size of your down payment just a little, which determines whether you pay private mortgage insurance
The DTI and deposit on a new auto loan or lease are less of a concern when you trade your old vehicle in at the dealer. The transaction automatically retires any existing balance and applies the remaining equity towards the deposit.