“John, last week I read an article suggesting that if I were to pay my mortgage or auto loan faster than scheduled it would improve my credit scores. That seems to make sense. Less debt equals better credit scores, right? Is it a good idea to thrown more money at my home loan?”
It seems like every day brings a new article revealing tricky ways to improve your credit scores. Many are wrong, some are partially wrong, but some are right.
If you read an article advising that your credit scores would improve by being out of debt that is correct.
Credit scores get a bad rap by a very vocal and uneducated minority of consumer advocates that suggest credit scores reward and even entice you to get into debt.
Of course, nothing is further from the truth.
Was someone from FICO standing over your shoulder forcing you to swipe your credit card?
Was someone from VantageScore Solutions leaning on you to finance an expensive car?
Credit is voluntary. Getting into debt is voluntary. In fact, credit scoring systems reward you considerably for NOT being in debt.
Revolving Debt Vs. Installment Debt
When we dissect the issue of debt it’s important to differentiate between the debt types as it pertains to credit scoring.
Revolving debt and installment debt are the two most common forms of debt that appear on credit reports.
Revolving debt would include credit cards. Installment debt includes fixed payment loans like mortgages and auto loans.
The influence of the two debt types are radically different. Revolving debt is very high risk where installment debt is considerably less risky.
If you were to default on a credit card you have no fear of the credit card issuer coming to your home and taking away the items purchased on the card.
If you were to default on an auto or home loan, and you’ll eventually lose your house or car.
That’s the difference between high risk debt and low risk debt…lenders have more exposure when there’s nothing to repossesses.
When you get into a large amount of installment debt, even hundreds of thousands of dollars, the impact on your credit scores is minimal.
When you get into even a modest amount of credit card debt your scores can be considerably lowered. This is important because it foreshadows the impact on your scores of paying it early.
What Paying Debt Down Faster Actually Does
Accelerating the pay off of your mortgage or auto loan is great because it will get you out of debt faster and will likely save you a considerable amount of interest.
But, do not expect it to make much of an impact to your credit scores. If the debt didn’t hurt much at the beginning of the loan it won’t improve much at the end of the loan.
A few years ago I sold a home and immediately shed almost $250,000 of installment debt. My score went up 4 points.
This is a real life example of the minimal influence of installment debt on your credit scores.
This should also act as a subtle warning to those of you who are thinking of creating taxable events simply to pay off installment debt.
Watch Out for Taxable Events
Borrowing from a 401K, selling a bond, or selling stock housed in a brokerage account will all create a taxable event.
If you did so just to knock out the last $25,000 of your auto loan or to pay down your mortgage, you made a huge mistake because of the tax liability and the lack of value the zero balance yields.
I remember a few years ago getting an angry email from a consumer who had sold $25,000 of stock to pay off his truck loan.
His scores didn’t move one point yet he had to pay taxes on the sale of the stock.
His assumption after reading some blog was the being out of debt is the best way to improve your credit scores.
Now if he would have used that money to pay off credit card debt, now we’re talking!
Even paying down a much more modest amount of revolving debt could have yielded an impressive score improvement.
Because you’re getting rid of high risk debt.
John Ulzheimer is the Credit Expert at CreditSesame.com, and a credit blogger at Mint.com, CreditCardInsider.com and the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO and Equifax, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. You can follow John on Twitter here.