You’ve just come into a little bit of money and you have decided that you want to pay off one or more of your debts.
The problem is this…you’re not sure which one to pay off first.
Conventional wisdom tells you that you should choose the debt with the highest interest rate because it’s the most expensive to service.
But, you also know that you’ll soon be in the market for a new car or a new home and your FICO credit score needs to be in tiptop shape.
Is there a “best” debt to pay off first in order to get the most credit score value?
The answer is yes, you can leverage your payoff to a better FICO or VantageScore credit score.
Here are your options and their pros and cons.
An installment debt has a fixed payment for a fixed period of time. And, an asset normally secures the debt.
Your auto loan is an example of an installment loan. Mortgages, home equity loans, student loans, boat loans, and unsecured personal loans are also common examples of installment loans.
Because most installment loans are collateralized they pose less of a risk to the lender because if you default they’ll simply repossess the car or home or boat or motorcycle, sell it at auction and cover some or all of the loan balance.
I realize that there are some installment loans that are not secured (like student loans and unsecured personal loans).
Still, student loans pose much less risk to the borrower than you would think because of the difficulty of getting out of paying it.
Don’t believe me?
Here’s what FICO says about the risk posed by student loan debt.
“It’s important to understand that while student loan debt can factor into the FICO® Score, revolving debt (like credit cards) has a larger influence. That’s because we’ve found that revolving type indebtedness has a stronger statistical correlation with future borrower performance than installment loan indebtedness.”
And here’s what Sarah Davies, VantageScore Solutions’ Senior Vice President for Analytics, Product Management and Research, says about the risk posed by installment debt rather than revolving credit card debt.
“Generally speaking, paying down credit card debt can be more beneficial to a consumer’s credit score than paying down an installment loan because it reduces the total amount a consumer owes as well as the percentage of credit used, thereby increasing the amount of credit available to that consumer.”
You also have to consider the fact that many installment debts have a tax benefit in the form of deductible interest.
So, even if your paying 6% in interest…you’re really not because the interest is being offset to some extent by the tax deduction.
Because of all of this the initial impact of installment debt to your FICO scores is minimal. And, because the initial impact is minimal any benefit from paying off the debt is also going to be minimal.
Don’t get me wrong, it’s great to not have any installment debt but don’t expect your scores to shoot through the roof when it has been paid off.
Revolving accounts allow you to pay some or all of the amount each month rather than a fixed amount. And, you have access to the line of credit even after the balance has been paid.
Credit cards are the most common type of revolving debt but home equity lines of credit (aka “HELOCs”) will also fall into this group.
Credit card debt is much more indicative of future credit risk.
First off it’s unsecured, which means the lender cannot come take something back if you stop making your payments.
You won’t lose your house or your car by defaulting on your credit card, which normally places your credit card payment lower on the priority list if you lose a job.
Further, credit card debt is normally much more expensive than any other debt mentioned in this article.
The average interest rate on a credit card is around 15% while rates on auto loans, mortgages and student loans are near or below 5%.
Because of these reasons taking on credit card debt is much more damaging to your credit scores. That’s the bad news.
The good news is that you can really improve your scores very quickly by using a loan payment calculator and by paying down your credit card debt. It’s by far the most actionable way to improve your credit scores.
So while it’s nice to not have a car payment, it’ll be much nicer to not have a credit card payment. Choose wisely.
John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling. He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, 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. Follow John on Twitter.