How Does Lowering Your Balance on a Loan Affect Your Credit Score?

So you come into some extra money. Paying off debt is one of the smartest ideas because it will save you money on finance changes and helps your credit score. Which type of debt you pay off first can have an even more significant impact on your score than just lowering your total debt obligation.

Identification

Paying off any debt will positively affect your credit score no matter what amount you send to the lender. The amount of debt you hold falls under the "amounts owed" category of the FICO scoring equation. The FICO formula is a trade secret, so you cannot determine exactly how much the lowering of a credit card balance will affect your score. Just make sure your lender reports the change in your balance to all three major credit bureaus.

Which Loan to Pay Off

If you have multiple open loans, you should pay off credit card balances first to maximize your credit score. The FICO factors in how much of your line of credit you are employing -- called credit utilization -- which falls under the "amounts owed" category. The installment loan ratio shows your remaining balance vs. the original amount of the loan in the FICO formula, but this counts for less than revolving credit utilization.

Paying Debts Could Backfire

Before you pay off a debt, review its date to see if you still legally owe it. Each state limits the time frame for which a creditor or collections agency may collect on a debt. This is typically no more than five years for certain types of credit. After seven years, the credit rating agencies cannot legally report a collections account or outstanding debt. Paying an old debt renews the date recorded and lowers your score.

Tip

Eliminating credit card debt is usually the best way to boost a credit score because credit cards almost always have the highest interest rate, suggests the Motley Fool. You could shift money to your loan payments. Your savings account, for instance, would have to pay more than 18 percent interest to earn more money than paying off credit cards at 12 percent interest. Home equity loans, taking money out against the value of your house, have interest rates as low as six percent.