In the race to achieve the best possible financial situation, the question of whether to build your credit or pay off debt first comes up a lot.
The good news? You actually don’t have to choose!
When it comes to paying off debt and building credit, these two goals can work very well together. Here’s how.
How does paying off debt help you build your credit?
Personally, I don’t see how building credit and paying off debt are considered opposing goals. Generally speaking, the things you do to better your finances can better your credit – unless you decide not to use credit at all.
In fact, paying off debt can greatly improve your credit thanks to your credit utilization ratio. Essentially the lower your revolving debt, the better your credit utilization ratio. And the better your credit utilization ratio, the better your credit score will be.
Here’s how it works. Say you have a credit card with a $5,000 balance and a $10,000 limit. Divide your balance by you limit, multiply by 100, and you’ll see that you’re using 50 percent of your available credit. Therefore, you have a 50 percent credit utilization ratio.
Now say you have four credit cards, each with a $2,500 limit. Credit card A has a $500 balance, credit card B a $1,000 balance, and credit cards C and D each have a $1,750 balance.
Add them all up and you’ll find that you have a $5,000 total balance and a $10,000 total credit limit. You’re using 50 percent of your available credit and thus have a 50 percent credit utilization ratio.
Here’s a visual example from Experian.
And if you’re wondering why we’re spending all this time talking about credit utilization, just know that it makes up 30 percent of your FICO credit score. It’s also highly influential on your VantageScore.
FICO and VantageScore, the two most popular credit scoring models, both recommend keeping your credit utilization at 30 percent or less. This is yet another reason to pay off your debt as quickly as you can.
What are the best ways to pay off debt?
Now that it’s clear how important debt payoff is if you want to build your credit, let’s talk about the best ways to pay off debt.
Two popular ways to pay off debt
In the world of debt payoff, debt avalanche and debt snowball reign as the most popular methods. The debt avalanche method requires you to pay your highest interest rate accounts first. Debt snowball, however, requires you to pay your lowest balance accounts first. Based on which method you choose, you’re going to pay your debt off in a certain order.
Here’s how to figure out which method is right for you:
- Make two lists of your debt accounts (credit cards, student loans, mortgage etc.).
- One one list, write out the balance next to each (from lowest to highest). This is your debt snowball list.
- On the other list, write out the interest rate next to each (from highest to lowest). This is your debt avalanche list.
Take a look at your two lists. If you’re in desperate need of motivation, the debt snowball can provide you small wins to keep you going from the beginning. But if you want to choose what makes more sense mathematically, the debt avalanche will get you out of debt faster.
No matter which method you choose, the first account on the list will be called your target account. Here’s what you’ll do next:
- Make minimum payments on all your accounts.
- If you have extra money available, apply that only to your target account.
- Once your target account is paid off, apply everything you were paying on that to your next target account – on top of the new target account’s minimum payment.
- Keep doing this – never lowering the monthly amount you pay – until you’re completely debt-free.
The most important thing is that you pick the method you’re most likely to stick with.
Lowering your interest rates
Besides targeting your debt payoff, there’s another useful method to paying debt off faster: lowering your interest rates.
One way to lower your interest rates is simply to ask. Believe it or not, you can call your credit card issuer and ask them to lower your interest rate.
This is more effective for those who have a long history with that card or issuer and who’ve never paid late. That’s because the credit card company wants to keep you as a customer and is more willing to lower your rate.
When you call, highlight any positive history you have with them. Don’t take the first no for an answer. Keep asking to speak to a supervisor until you either get a lower rate or get a final “no.”
You can also lower your rate by consolidating your credit card debt onto a balance transfer credit card. Balance transfer credit cards often come with a zero percent interest rate for a limited period of time and are specifically used to pay off other credit cards.
As long as you either pay off your balance transfer card before the introductory period is over or get another balance transfer card right before it ends, you can work on paying off debt without interest getting in the way.
And if you don’t want to deal with another credit card, you could also try to consolidate your debt with a debt consolidation loan. Just make sure the loan comes at a lower interest rate than your credit card.
If you’re curious to see how much consolidation might expedite your debt repayment, use this calculator to find out.
Credit Card Consolidation Calculator
Principles to follow to build your credit
Whenever you’re trying to establish your financial priorities, remember that good financial habits can enable you to build your credit in a positive way.
And don’t think you can avoid credit altogether. Credit scores, after all, rely on you having some credit behaviors to measure.
The thing to remember when building credit is that the principles are simple. Pay all your accounts on time, keep your debt as low as possible, and only apply for credit only when you need it.
These behaviors will show creditors that you can manage credit responsibly. And for that, you’ll benefit from easier credit approval and lower interest rates. In other words, you can access credit when you need it and more of your money goes to the balance than interest.
Interested in a personal loan?Here are the top personal loan lenders of 2018!
|Lender||APR Range||Loan Amount|
|1 Includes AutoPay discount. Important Disclosures for SoFi.
2 Includes AutoPay discount. Important Disclosures for Payoff.
3 Important Disclosures for FreedomPlus.
4 Important Disclosures for Citizens Bank.
Citizens Bank Disclosures
5 Important Disclosures for LendingPoint.
6 Important Disclosures for LendingClub.
All loans made by WebBank, Member FDIC. Your actual rate depends upon credit score, loan amount, loan term, and credit usage & history. The APR ranges from 6.16% to 35.89%. For example, you could receive a loan of $6,000 with an interest rate of 7.99% and a 5.00% origination fee of $300 for an APR of 11.51%. In this example, you will receive $5,700 and will make 36 monthly payments of $187.99. The total amount repayable will be $6,767.64. Your APR will be determined based on your credit at time of application. The origination fee ranges from 1% to 6% and the average origination fee is 5.49% as of Q1 2017. There is no down payment and there is never a prepayment penalty. Closing of your loan is contingent upon your agreement of all the required agreements and disclosures on the www.lendingclub.com website. All loans via LendingClub have a minimum repayment term of 36 months or longer.
7 Important Disclosures for Earnest.
8 Important Disclosures for Avant.
* The actual rate and loan amount that a customer qualifies for may vary based on credit determination and other factors. Funds are generally deposited via ACH for delivery next business day if approved by 4:30pm CT Monday-Friday. Avant branded credit products are issued by WebBank, member FDIC.
** Example: A $5,700 loan with an administration fee of 4.75% and an amount financed of $5,429.25, repayable in 36 monthly installments, would have an APR of 29.95% and monthly payments of $230.33
* Important Disclosures for Upgrade Bank.
Upgrade Bank Disclosures
** Accept your loan offer and your funds will be sent to your bank via ACH within one (1) business day of clearing necessary verifications. Availability of the funds is dependent on how quickly your bank processes this transaction. From the time of approval, funds should be available within four (4) business days.
|7.73% – 29.99%||$1,000 - $50,000||Visit Upstart|
|6.26% – 14.87%1||$5,000 - $100,000||Visit SoFi|
|6.99% – 35.97%*||$1,000 - $50,000||Visit Upgrade|
|5.99% – 24.99%2||$5,000 - $35,000||Visit Payoff|
|4.99% – 29.99%3||$10,000 - $35,000||Visit FreedomPlus|
|5.99% – 18.99%4||$5,000 - $50,000||Visit Citizens|
|15.49% – 34.49%5||$2,000 - $25,000||Visit LendingPoint|
|6.16% – 35.89%6||$1,000 - $40,000||Visit LendingClub|
|6.99% – 18.24%7||$5,000 - $75,000||Visit Earnest|
|9.95% – 35.99%8||$2,000 - $35,000||Visit Avant|