Credit scores are important because lenders consider them when deciding whether to approve a loan or not. A high credit score indicates you're a low-risk borrower, which could lead to a lower interest rate. On the other hand, a low credit score could mean you won't be approved for a loan or get a higher interest rate. So, it's in your best interest to keep your credit score as high as possible.
Paying off your credit card balances is one way to improve your credit score, although it’s not as straightforward as it looks. Depending on different factors like credit utilization, the amount paid, and total debt owed, your credit score can improve drastically or may even take a dip when you pay off your credit card loan. Here’s how it works.
Contents
There are several factors that credit scoring companies consider when determining your credit score. These factors are different for each company and are not fully disclosed. However, FICO, the most common credit scoring agency, shares its scoring factors on its website.
These factors are:
To get the maximum points for each factor, you should:
The credit card utilization rate is an essential factor in determining your credit score. Companies look at how much you’ve borrowed versus how much is available for you to borrow. Ideally, you should borrow less than 30% of what’s available to you to get a high score. A low credit utilization rate increases your credit score.
You can always control your credit card utilization rate by paying off your credit card loans to increase the available credit limit.
The impact of paying your credit card loans depends on the state of your credit before the payment. Your credit score will jump several points if you suddenly pay off your credit cards and drastically reduce your debt. However, your score won't rise as much if you have low credit utilization, even if you pay off the entire amount owed.
If you decide to close a credit card, even if the utilization is zero and you’ve paid off all outstanding debts on that card, your credit score could still dive. Credit companies look at the total utilization across all your cards when computing your credit score. A closed card decreases your total utilization because it reduces your available credit. It’s better to keep a card with zero debt open since this increases your overall credit line and improves your utilization rate. However, if you have bad spending habits or if the card has annual fees that you’d rather not pay, then closing the card may be a better option.
Credit card issuers send monthly reports to credit bureaus, so you can expect the impact of your payment to take effect within a month. Credit scores are calculated when credit is pulled, and the latest information available is used to determine the score. As a result, paying off your credit card balances is the fastest way to boost your credit score.
However, note that not all types of credit card payments will improve your credit score. If you paid using a balance transfer to a new card, a HELOC, or a new line of credit, you shouldn’t expect to see a change in your credit score. This type of payment essentially means you still owe the exact amount. Credit bureaus look at your total credit — not just the credit on one card. The best payment type to boost your credit score is by paying using cash, debt consolidation or personal loan, or a cash-out refinance.
Ultimately, the best way to improve your credit score is to have the least amount of debt. If you should borrow or utilize your credit card, make sure you have enough cash to pay for the purchase. As soon as the bill is due, pay for the credit card balance in full. Avoiding late payments and maxing out your credit card will also keep your credit score healthy.
For more articles on wisely managing credit card debt, check out Processing Card’s blog section.
Florence Carpenter is passionate about ensuring that the process of opening merchant accounts is as straightforward as possible. She graduated from the University of Michigan with a bachelor’s degree in Marketing.
