There are a variety of strategies to improve your or, (if you are a lending, real estate or insurance professional), your client’s credit scores. You can remove negative credit items, or build new credit (often through the use of credit cards and credit builder or personal loans). You or your clients can also be added as an authorized user, to an existing credit card, or reduce current credit card balances.
One question we often hear, is whether reducing the balance on installment loans, such as student loans, auto loans, personal loans, or mortgage loans, will help boost credit scores. Many prospective homebuyers (including maybe you, or one of your clients), attempt to boost their credit scores, by paying off some or all of their auto or student loan early (that is, paying above the required monthly amount).
Does this work? And is it the most effective short-term strategy for raising a credit score? In a nutshell, it can help, but not much. Paying down balances on revolving accounts (i.e. credit cards), is far more effective than reducing balances on installment accounts. Let’s take a look at why.
How much debt you owe on various credit accounts, makes up 30% of your FICO credit score. This part of your FICO score is decided both by installment accounts (any loan with a fixed borrowing amount, such as mortgages, student loans, auto loans, and personal loans), as well as revolving accounts (such as credit cards, store cards and charge cards). ‘
As credit expert John Ulzheimer (a former employee of both Equifax and FICO) explains, your revolving account debt amounts, even if accounts are paid on time, often plays a significantly larger role in deciding your FICO score, than how much your installment accounts. Why? Revolving debt is “much more predictive or indicative of elevated credit risk. As such, it’s going to be much more harmful to your credit scores.”
Why is this? Since installment debt is often secured by an asset (i.e. your home or your car), you are less likely to stop paying on those accounts (otherwise, you’ll lose your house or your car). With credit cards, there is nothing that can be seized (outside of your bank account or paycheck in a lawsuit, which takes a long time), if you stop paying. With the exception of student loans and personal loans (which are not secured by an asset), installment accounts involve somewhat less risk.
Additionally, with revolving accounts, you or your clients have greater choice, in deciding how much you pay each month. As a result, it is seen as being more predictive of your credit management skills. Outside of meeting your minimum monthly payment, you have the choice of paying off your account, or carrying a balance (either small or large). How exactly you or your clients handle a revolving account, is very much in your/their hands.
This isn’t to stay that debt on installment accounts don’t affect FICO scores. If your balance to loan ratio is high (meaning, the loan is relatively new, and you haven’t paid down much of it just yet), then your credit score could be reduced. What is a high balance to loan ratio? If over 80% of your loan is still owed, you might see a slight hit to your FICO score. In many cases, this is in part due to the account being relatively new, which reduces the average age of accounts, and thus, your credit score.
In these cases, we suggest a two part approach. First, try to reduce your balance on every credit card account, except for one, to $0. On that final account, you’ll want to carry a small balance (around 2-5% of your credit limit). Carrying this balance shows FICO that you are actually using credit; not doing so, could reduce your credit score. If you or your client doesn’t have enough money to do this right now, focus on first reducing the balance on every account to below 30% of the limit, and the paying down balances further, implementing the above approach.
After this, if any installment account has a balance to loan ratio over 80%, consider reducing the balance to slightly below 80%. Given the limited impact that installment accounts have on credit scores, this won’t boost your score in the way that reducing revolving account balances did, but it can have some impact. Do not, however, pay off the loan in full, as that could reduce your credit score further, since you’ll have one less active installment account reporting.
We also suggest not opening any major installment credit account (such as an auto or personal loan), in the 12 months before you or your client is aiming for a stronger credit score. This will help you reduce the chances of having a balance of over 80% on any installment account, and of having your credit score reduced, due to having new accounts.
Shiva Bhaskar is an experienced consumer credit attorney, and the cofounder of Tier One Credit (www.tieronecredit.com), a credit consulting firm dedicated to helping every American enjoy the best credit score possible. Shiva can be reached by email at [email protected].
