Does Paying Off Debt Improve Your Credit Profile?

Debt doesn’t have to last forever. You’ve got options to address your debt, whether that’s a DIY payoff plan, debt relief, or something else. Once you do, you’ll find that life on the other side of it is brighter. Dealing with your debt is one of the most important steps to good credit. Let’s take a closer look at how paying off your debt could help you improve your credit, and a few options to tackle your debt. 

Freedom Debt Relief is not a Credit Repair Organization and does not provide or offer services or advice to repair, modify, or improve your credit.

The Role Debt Plays in Determining Your Credit Score

If you hope to improve your credit, learning about the role debt plays in your credit rating is a good first step to get you on your way. You have multiple credit scores, and the amount of debt you have has a significant impact on all of them. 

The most widely used credit score is the FICO® Score. The amount of debt you carry is reflected in the second-most significant part of your FICO® Score: amounts owed, which accounts for 30% of your score. 

Amounts owed and credit utilization

“Amounts owed” includes your current balances across all your loans and credit cards, how many accounts have balances, and how much you owe relative to how much you could borrow (in the case of credit cards or lines of credit). And FICO isn’t unique in considering this factor when determining your credit scores—VantageScore, another popular credit score, does too. 

For VantageScore, total credit usage is ranked as “highly influential.” This category includes credit utilization rate for credit cards and how much money you own on installment loans relative to how much you initially borrowed. 

Credit utilization rate is a percentage based on how much debt you have when compared to how much credit you have in your name. 

For example, if you have three credit cards with limits of $3,000, $4,000, and $5,000 (for a total of $12,000) and are carrying $3,000 in debt across all three, you have a credit utilization ratio of 25%. The lower you can get it, the better. As this percentage goes up, it’s more likely to cause your credit score to drop. Also, be careful not to max out any individual card—maxing out a credit card is terrible for your credit score. 

So does paying off debt improve your credit? Based on this, we can conclude that yes, paying off or at least paying down debt is very likely to have a positive impact on your credit profile. And this is especially true if you’re struggling with credit card debt. 

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Credit Card Debt’s Specific Impact On Credit

Credit cards can work for you or against you.

Credit card debt is an obstacle between you and a great credit score. High utilization is one of the most common culprits when it comes to low credit scores. Generally speaking, as utilization goes up, scores go down. On the other hand, the opposite is also true. 

Let’s say you have one credit card. For the sake of this example, let’s also assume that you don’t have any late payments or collection accounts on your credit reports, or any other data that could pull down your score. You checked a free credit score website and it said that the only area where you need improvement is credit utilization.

The credit limit is $5,000 and your balance is currently $4,999. You decide to attack that debt and pay it off in $1,000 monthly payments. If you’re monitoring your credit score, you could see noticeable gains each time a lower balance is reported. 

This is a hypothetical example, and we can’t predict what will happen to your score. The point is that utilization has a profound, visible effect on credit scores. It’s not possible to have excellent credit with high utilization. 

Avoiding credit card debt is a great way to build credit over time. It’s possible to use your credit card and still show a zero balance on your credit report. All you have to do is find out when your credit card issuer reports your account activity to the credit bureaus. That’s typically on or right after your statement closing date each month. You could use your card to your heart’s content, and as long as you pay off your balance before the date it’s reported, your credit report will show low or no utilization. 

Debt Payoff Strategies

Here are a few options for tackling your debt and improving your credit profile. 

Debt snowball or debt avalanche

If you have the financial flexibility and wiggle room in your budget to pay extra on your debt to get clear of it, consider the debt snowball and debt avalanche payoff strategies. 

The debt snowball strategy is probably better for most people. The debt snowball method means focusing on sending any extra money to pay down your lowest balance debts first. That helps you reach your first payoff the soonest. Seeing those $0 balances can be a rush, and it offers motivation to keep going. 

In an avalanche, you focus your extra cash on the debts with the highest interest rates first. This could save you money in the long run. But if your highest-rate debt is also your largest, it may take a long time to make real progress, and you could grow frustrated and give up. 

Ultimately, the choice is yours—both the debt snowball and the debt avalanche are great ways to structure your debt payoff. 

Debt consolidation

If you qualify, you might be able to consolidate your debt and get a jump on paying it off with less interest (it doesn’t make sense to consolidate debts to a loan with a higher interest rate). You have a few options for debt consolidation. 

Personal loans often come with lower interest rates than credit cards, so if you can qualify for a personal loan to pay off your credit cards, you could get set payment amounts and a set payoff date to boot. This is only a good option if you’re sure you won’t charge your paid-off credit cards back up again. Otherwise, you might be left in a deeper debt hole than before. 

If you own a home, you might consider consolidating debt with a home equity loan or line of credit (HELOC). This is likely to come with a lower interest rate than credit cards or personal loans because the loan is guaranteed by your home. But here too, you should approach with caution. If you can’t make the loan payments, you risk losing your home.  

Credit counseling 

Want some professional help with your debt? That can be a great option. Nonprofit credit counseling agencies can help you create a budget, find places you can cut spending, and create a debt management plan. Under a debt management plan, you pay a set amount every month, then the money is distributed to your various creditors on your behalf. 

Debt management plans don’t have a high success rate, thanks to the often high monthly payment requirements, and you usually need to close your credit cards as part of the process. This can mean a hit to your credit scores. But they can help you reset your finances so you can rebuild and work toward a higher credit score over time. 

Debt settlement

Debt settlement is the process of negotiating with your creditors to accept less than what you owe. You can tackle debt settlement on your own, or with the help of a debt settlement company. 

Debt settlement is for someone experiencing a hardship who genuinely can’t afford to fully repay their debts. Many people who pursue debt settlement are already falling behind on their bills. There is no minimum credit score for debt settlement.

You are likely to experience credit score damage if you opt for debt settlement. The way it works is that you’ll need to set aside money to offer your creditors. If you don’t have that money handy, you’ll need to save it up. That can be hard while you’re also trying to stay current on your debt payments, so most people choose to stop making their debt payments during this time. Any time you stop paying your bills you should expect serious credit score damage. 

On the other hand, stopping payments also sends a clear distress signal to your creditors and could open the door to negotiation conversations. 

Debt settlement can be a very effective way to get relief from unsecured debts like medical bills and credit cards. 

Bankruptcy

Bankruptcy is a formal legal process for eliminating debts, and if you’re struggling with your finances, it could make the most sense financially. There are two main types of bankruptcies for individuals: 

• Chapter 7, which entirely wipes out your unsecured debt

• Chapter 13, which restructures your debt and gives you a plan to pay it off.

Chapter 7 bankruptcy is means-tested—if the court decides that you can’t afford a payment, you could get free of your unsecured debts in a few months. The tradeoff is that you might have to give up some of the things you own. Everyone gets to keep certain possessions, like their clothing and furniture, and tools for work. The court will sell certain assets and give the money to your creditors. 

If your debt is mostly on credit cards and you don’t own much or anything that the court could sell, Chapter 7 might be an option to consider.

Chapter 13 takes longer (five years for most people, three years if you’re low income). You’ll be required to pay all of your disposable income into your plan. You don’t have to give up any assets, but their value will be factored into your payment plan. With attorney fees and court costs, it’s possible to pay more in a Chapter 13 case than you would have if you paid the debts off yourself. 

One reason someone might opt for Chapter 13 is to protect assets. All bankruptcies offer legal protection from creditors, so if your home is in foreclosure, for example, a Chapter 13 case could give you the chance to get caught up.  

Bankruptcy filings are public, and stay on your credit report for seven to 10 years. 

Yes, Paying off Debt Could Improve Your Credit—Get Started Today

Having less debt to manage can do a lot of good. When your finances are stable and you’re working toward your future, you’ll naturally put yourself in a better position to focus on building a healthy credit profile. So why not review your options and get started today?