Paying Down Debt: The Right and Wrong Ways to Do It
A score of 740 or above is considered optimal, while scores below 680 will cost you more in interest in fees, and could even put you in danger of not qualifying for a loan. When it comes time to purchase a home or refinance, the better your score, the more you will save.
It's a step in the right direction, says Todd Huettner, president of Huettner Capital, in Denver, Colo., as people look to get back in the black and improve their finances. "There is no doubt that people are looking to pay down their debt," he says, "and, when they can, get rid of it altogether."
But paying off debt, if not done right, can actually hurt your credit rating.
"It's very frustrating," says Huettner. "You say, 'I did everything right, how is it possible?' But there are some counter-intuitive things, where doing the right thing is wrong thing."
Here are a few myths you need to be aware of before you start paying down debt:
What you think you know: Paying off all your debt and closing all your credit cards is the best way to a perfect credit score.
What you don't know: Having zero debt and zero credit cards equals a credit score of 0.
"I see people who pay off all their debt, and it creates a problem they are not aware of," says Huettner. "A credit report is an analysis of your probability of paying your bills. If you have no debt, and you don't use credit cards for 24 months, there is nothing for the company to evaluate, and you'll have no score."
The easy fix, says Huettner, is to open a credit card, charge something, and pay the bill. Better yet, have two credit cards. "I'm all for paying things off, but in this day and age, you need a credit score. You can be debt-free but maintain a credit profile: Keep two or three cards, and put one item every six months one each of the cards, and pay it off. That's enough to keep score pretty high."
What you think you know: Closing credit cards right before you apply for a mortgage will help to improve your score.
What you don't know: Closing a credit card can lower your credit score in the short run.
"If you have four credit cards, keep them open," says Huettner. "It doesn't mean you have to use them. You have improved your score by paying it down, but by closing it, that history is lost." The credit rating companies will evaluate your behavior across all accounts, he said, and having these accounts open will work in your favor.
What you think you know: As long as you pay off your credit cards each month, it doesn't matter how many you have.
What you don't know: You can have too many credit cards.
While having a few credit cards is important for a strong credit rating, "having a card for every single store is not a good thing," said Huettner.
"The danger is you are overexposed," adds Daniel Penrod, senior industry analyst at California and Nevada Credit Union Leagues, based in Ontario, Calif. "The lender will add up the total of your potential revolving debt. If you have a lot of open funds, then that is a major red flag."
Huettner also cautions against so many cards for the simple reason that you are more likely to overlook a payment when you have more payments to make. And one late payment, he says, is all it takes for your credit rating to go down.
What you think you know: It's more important to pay off one credit card, even if I don't pay on another.
What you don't know: You don't get partial credit for paying your bills.
Get Your 2010 Credit Score
What you think you know: Check your credit score when you are getting ready to apply for a mortgage or refinance.
What you don't know: You needed to do this a year ago.
"Credit scores are not an instant gratification piece," says Penrod."It takes months to move in any direction." If there are any problems with your credit score, whether it is a mistake on your report or a loan that needs to be repaired, "You need to start early, just as you started getting that down payment ready early."