|by Brooke Kaelin|
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Executive Summary – Paying off a credit card has positive impact. But there are a couple of issues that may not result in a significant improvement in one’s credit score. In this post, we will explain why paying off your credit card debt has a positive impact. We will also highlight mistakes consumers make after paying off their credit card debt that offsets the positives.
Postive Impact Because of Credit Utilization Ratio – According to Experian (one of the three major credit bureaus), paying off your credit card debt is always a positive thing. The reason why paying off your credit card debt is positive for your credit score is because not only because credit bureaus look at an individual’s credit card debt, but also because their credit utilization ratio will improve when credit card is paid off as measured against availability of credit1. MyFICO also advises consumers to have as little credit card debt as possible2.
Brief Explanation of Credit Utilization Ratio – According to MyFico3, amounts owed represent 30% of the component that goes into your credit score. Under amounts owed, credit utilization is a factor. It is simply the amount of balance you carry against the amount of credit lines that is available. There is no magical number as to what an ideal credit utilization ratio number is. Lots of sites throw up a number like 30% is a good ratio. But in reality, the credit bureaus and MyFICO all say that the lower the ratio is, the better. Their statistical models have shown that people with higher credit utilization ratio are more likely to have a late payment than a person with low ratio.
Mistake 1: Closing Your Credit Card After Paying It Off – Very often, consumers decide to close the credit card that they have just paid off because they just want to have nothing to do with that card again.
Both MyFICO2 and Experian1 advice against closing a credit card to raise your score and say it will most likely have a negative impact. The reason is because by closing your credit card, you will be reducing the amount of credit lines available and hence, your credit utilization score will increase (which is frowned upon by credit bureaus).
Here is a simple example. You have two credit cards. Both have $5,000 credit limits, which makes your total credit limit of $10,000. Let’s say you have $3,000 balance on each card (total of $6,000). That means you credit utilization ratio is 60%. If you pay off $3,000 from one card, you would have reduced your debt by $3,000 and bring your credit utilization rate down to 30%. But if you closed the card you just paid off, your ratio would still be at 60%.
Reader’s Question – One of our readers, Sergio, sent us this question:
I have a credit card with a limit of $3,000.00, my balance as of today is $2,100.00, I also have a line of credit of $9,000.00. As of yesterday my balance in my line of credit was $6,935.70, what I did today was pay the $6,935.70 out of my own pocket (without getting another loan) and zeroed out the line of credit without closing it. The balance is now $0.00. Give or take, how will it affect my credit in terms of points and how long do you think it will take for my credit score to raise. My credit score is about 650 (not the greatest) and am working on getting it better.
Thanks for the advice and help,
Thanks for your question Sergio!
Congratulations! Paying off that card was a huge accomplishment – and it put you under 20% of your total available credit.
The credit bureaus (and FICO) do not publish the exact formulas that they use to compute your score. Because of that, I can’t tell you exactly how much it will raise your score, but I can tell you that it will definitely raise it. The amount you owe makes up 30% of your credit score.
Before you paid off your balance, the amount of debt you had was $9,035.75 ($2,100 + $6,935.70). Set against your available credit of $12,000 ($3,000 on your card + $9,000), your credit utilization ratio is 75.30%
Now that you have paid off your line of credit, your credit utilization ratio is now 17.5% ($2,100 divided by $12,000). This is a massive improvement. Nobody can say for sure how much your credit score will go up, but I suspect there will be a significant improvement. Getting your credit utilization ratio from 75% to 17.5% is a huge leap.
You will be able to check your new improved score the month following the payoff. If you keep the balance low on that card, pay on time, and continue paying down the card with the $2,100 balance, you will see your score continue to go up, and up, and up.
You are right to keep the paid off account open – don’t close that one whatever you do or you will see your score drop instead.
You should probably pick up a cheap credit monitoring service for a little while. Once you see your scores hit over 700 try applying for a new credit card. Don’t charge on that one either. Just put it back for emergencies. Better yet, if you can get a rewards card, you could use it just for gas and utilities, and then pay it off at the end of every month.
The important thing to understand is that you are making all the right moves, taking all the right steps, to repair your credit. As long as you keep on doing what you are doing you could well see your score in the high 700s within the next couple of years. Probably even sooner than that if you open a third card.
Be aware that when you do open that third card your score will temporarily drop a few points (because of the inquiry.) As long as you keep your balance under about 20% of your total available credit your score will go right back up even faster than before.
Also, when you monitor your reports, look at them carefully. If your score is at 650 now it’s probably safe to assume you may have had some late payments, or gone over the limit a couple of times. See if there is anything on your existing reports you can challenge. Any negative information that you can remove will raise your score that much quicker.
One warning: Don’t challenge too many things at once or you will get your score frozen until the disputes are resolved. It does not hurt your score if that happens, but you will not be able to get a loan or a new credit card as long as it is going on.
Thanks for your question!
Another Reader Question – Here is another reader question we typically get.
I have a 606 credit score, and I need to get to a 640 in order to qualify for a home loan. I just paid off my credit cards and 8 creditors. Will my score go up?
I don’t have stellar credit. I have just paid off the balances on ALL  of my credit cards [Totaling $6733.00]. How far will this action go in improving my credit score and lowering my average interest rate, which is currently near 23-28%?
Mr Keith Wilson
In both cases above, we should see an improvement in credit. We cannot say how much for sure. What is not clear is what were their credit limits prior to them paying off their credit card debt. If their balance was close to their credit limit and they not close any cards, then both might see very good improvements.