Reader Question: Does Paying Off Debt Lower Credit Scores?

by David Ning · 12 comments

Welcome to our reader question series where we feature an inquiry submitted by the MoneyNing community, along with our answers.

Today’s question touches on so many subjects we discuss here on the blog: Marriage and finances, credit, and paying off debt. Show her some support by letting her know how she can handle this delicate matter.

Reader Question:

Currently I have $18,564.55 in total of consumer debt. My hubby has accumulated 3 times that with consumer, car loan and student loans. We want a house, and we are living with his parents until we can afford a down payment. My problem is that we’re not on the same page. I started a job recently and I’m planning to put away $1,000 in an emergency fund. After that, I will start my debt snowball. My goal is to get rid of the credit cards one by one, putting them at zero as much and as fast as possible.

However, when I talk to him about it, his view is that as long as we reduce every card to 30% of their limit, we will increase our score and we will be fine. His argument is that when they calculate our score and consider our debt to income ratio, a 0 to income will have a negative impact. No matter how he explains that being in debt partially is good, I don’t understand. My logic is that I borrowed money, I need to pay up. I feel like keeping a balance and paying interest is paying for stuff over and over again no matter how small the interest may be.

I’m very frustrated because I am convinced that he is wrong and he gets aggravated because he thinks I’m wrong. What can I do? Help.

MoneyNing’s Answer:

Living with your parents are brave, and admirable. I know there must be some inconveniences but this moves seems to indicate that both you and your husband are willing to sacrifice in order for a better future. So with that said, I think both of you have the same goals in mind, and your husband is more of a saver than you think.

I assume your husband is talking about credit scores for purposes of buying a home, so here’s my take. If your husband has three times your debt amount, you two have accumulated about $75,000 in debt. That’s high under any circumstances, and will negatively affect the borrowing power when you two decide to apply for a loan. Generally, when an officer looks at loan applications, they will try to figure out your income and ALL your debt payments, and try to figure out whether the loan is affordable to you. Obviously, the higher your payments, the less you have available to pay the mortgage. Thus, the higher your debt, the smaller the loan you can obtain.

It’s true that showing the ability to handle different debts may increase your credit score, but in general, the higher your credit utilization rate (meaning, the higher your credit limit versus your debt), the better. Therefore, it’s still best to try to lower it. Your husband’s argument of having NO debt may negatively affect your score. That’s true, but it seems like you have quite some time before you can pay off everything. In your case, I will still suggest reducing your debt. If your husband feels uncomfortable to eliminate everything (his $0 argument), he can still maintain a small amount but $75,000 is not small by any stretch.

A good strategy to move forward from this deadlock between the two of you is to find a third person to discuss your finances with. If the third party is logical and responsible (perhaps a financial planner of some type), you can be sure that he will also suggest lowering your debts, even if he doesn’t want you to completely eliminate it. Another way is to keep executing your plan, and showing him how commitment to reducing your debt can really pay off. A third way might be to calculate how much interest he is actually paying every month with his loans. Once he understands how much of his payments are interests related, he may realize just how much money is wasted because of your family’s debt load.

If you follow my blog, you will realize that I’m not so “hot” on having debt at all. I just don’t buy the argument that debt is good. Saying debt is great as long as the borrower can bear the payments is like saying cancer is great as long as the medication can treat the patient. There’s a certain kind of freedom when you don’t have any payments to make. I hope that you and your husband will find a middle ground and be debt free sooner rather than later.

David Ning, founder MoneyNing.com

What Do You Think?

Sometimes, asking for help is the hardest step to make. This reader also agreed to put her story out in the public, which isn’t always easy either. Please help by offering your opinions. Be nice, and your efforts will help at least one person today.

Note: It dawned on me that there might be some of you who want to send me questions but think that I’m too busy to respond. So let me say this.

I love the interaction and helping out.

I may not be able to respond right away because the quantities of emails that come daily just get too overwhelming sometimes, but I love to help. I don’t claim to be an expert, though the nature of my business allows me to think and read about money matters much more than the average joe. If you would like a second opinion, someone to talk to or even the occasional advice, I’m all ears (or in our case, through email, I’m all eyes).

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  • Garry kerr says:

    credit scores for purposes of buying a home.some legitimate past due accounts that are paid or in good standing now, but it was worth it.Finally, to pay off your debt, the best thing you can do.

  • Rob says:

    Carrying around $75k in debt is not fun. Especially in this economy. I would pay off all your current debt, one loan at a time. When you have just a couple loans left to pay off, go ahead and try and buy a house. Then you’ll be able to afford a larger house.

  • CD Phi says:

    I think that the best thing to do is pay off debt as fast as possible, too. I don’t think holding debt can really be good for your credit score because being debt free looks the best when it comes to applying for loans.

  • A few months back I pulled my FICO score. One of the cool features that came with that was a Credit Simulator. When I ran different scenarios I found that my credit score would actually go up if I wasn’t 100% debt free. However if I had more than about 5% of my credit being used my score would also fall. The simulator is not an exact measurement, they only give you ranges but it appears about a 5% debt/credit ratio gives the greatest score.

    On the other hand once you are debt free do you really care that much about whether the credit score is 785 or 800?

  • Amir S says:

    About 4 years a go, my FICO score was around 580. Now, I’m at 803 (only 1% have a FICO score of over 800), so I know a thing or two about credit.

    First of all, your husband is very WRONG. Go ahead and lower your debt by as much as you can. No one is going to penalize you (including FICO) for not throwing your money away on interest. Even if you get them all to zero, you can still carry a month to month balance, which will show activity on your report. Besides, even if the banks don’t like you paying in full every month, they can’t tell that just by looking at your credit report. All it shows on there is that u have a balance; there’s no indication that you paid your previous month’s balance in full (at least none that I can see on there)… I buy EVERYTHING with credit cards, just so I get the miles, the cash-backs, the extended warranties, the travel insurance, the dispute rights, having the benefit of keeping my money for an extra two months, and so I can keep better track of what I spend every penny on. BUT, I ALWAYS pay the balance in FULL by the due date. Once you’re debt free, it is EXTREMELY important to pay them off at the end of the month. That way you get all the benefits and none of the pain.

    Here are somethings you can do to increase your score –

    -Pay down your debt. I use about 2% of my available credit, and I pay that off every month. About 3 years a go, I had 20k in credit card debt; the more I paid off, the higher my score went.

    -Never ever close any of your oldest credit cards. The longer your open credit history, the better. I have about 15 cards.

    -DO NOT open any new credit cards, unless they give you some outrageous rewards. For example, I just opened a Chase card that gave me 100,000 free miles. Opening that account, lowered my score by about 8 points, but getting two free trips to Europe was worth it.

    -Every two to four months, call up your existing credit card companies and ask them to increase your limit (a lot of times, you can do this online). Most of them will consider it without putting a hard inquiry on your report. Be sure to ask them though; if they say they’ll put an inquiry on there, tell them to forget about it, and move on to the next card… While you’re at it, ask them to lower your interest rate as well, it doesn’t hurt to ask, and often, they’ll do it.

    -Always pay on time – This one is obvious, but it’s very important.

    -Check your report for any errors, if there are errors, dispute them immediately. Even if you have some legitimate past due accounts that are paid or in good standing now, you should call up the creditor to see if they’ll take them off. Often, they will if you insist. My sister had something like 7 old past due payments on her report, and once I had her call every one of them, I think at least 3 or 4 of them were removed. She had to talk to supervisors and make followup calls, and put some serious effort into it, but it was worth it.

    Finally, to pay off your debt, the best thing you can do (if your score is high enough) is to find one or two of those zero interest cards and transfer your balances to them. They’re hard to come by these days, but even if you find one that gives you 9 months interest-free, that would make a HUMONGOUS difference. Just make sure that the transfer fee is no more than 3%.

    Okay, this ran a bit longer than I was planning, but hopefully it helps, and good luck on your quest to becoming debt free 🙂

  • Kristine says:

    3 Things to Address:
    “$1,000 in an emergency fund” – $1000 is a great start to your emergency fund. Work towards putting away 3-6 months worth of expenses away in your emergency fund. This protects you for that time period if either of you are out of work.

    “debt partially is good” – Never stay in debt for the sake of “being in debt.” Unless you are using that debt for productive reasons (i.e. investing), then there is no reason to carry debt for the sake of it. But, building your emergency fund is a great reason to put off eliminating consumer debt altogether.

    “30%” – It is true that having a 30% credit utilization rate will positively improve your credit score. It shows that you are able to handle the amount of credit you have, and it poses less risk to a potential lender.

    Also, when your credit score is pulled, it is a snapshot in time. Lending institutions will not know whether you pay your credit card bill off at the end of the month or leave a balance. I think the myth of leaving a balance was started by the credit card companies…Save the money you otherwise would have paid towards the interest, and put it in your savings account. Doing this may also help your credit score, lowering your utilization ratio.

    I think you have the right idea. Start up your emergency fund (3-6 months of expenses). Once established, start the snowball rolling in paying off your credit card debt. Pay more on your student loans last since at least some of the interest is tax deductible. On your credit cards, attack the card that affects your cashflow the most. Once that card is paid off, roll that payment to the next credit card, creating your snowball effect. But don’t close any of your credit cards. That will have an adverse affect on your credit score.

    If there is still debate between you and your hubby, do some more research individually and compare. I wish you the best in buying your home.

  • Alcoholic Millionaire says:

    The 30% debt to limit ratio certainly does not apply to the car loan or the student loans. I’ve never heard of that magic 30% number before and I don’t think it’s completely true. It may be that over 30% is bad, but under 30% would certainly be better. The one caveat to this is if you completely pay off your card and then the credit card company moves your credit limit much lower (they have been doing things like this recently) At that point your overall credit line might dip slightly and you may loose a few points on your score. But as Charles mentioned the amount of interest that your paying on the debt is not worth playing “kissy face” with the banks.

    • Joe Stru rdell says:

      Why not build a ton of wealth and then loan money to yourself; with interest? Who cares what the credit score is if one never borrows any money at all? This 30% fool will never ever experience a positive NET WORTH!

      I noted this website is placing ads for cheaper cable from the big playas; another HORRIBLE INVESTMENT! KILL YOUR TV!

  • Joseph says:

    I don’t agree that the couple needs to maintain a 30% ratio just to prove to lenders that they can pay off debts. The 30% is just a theoretical threshold where going above will cause a negative effect on their credit. If they just lower it to 5% (or even less), they are still making monthly payments on time and the ability to make payments can still be shown. However, at 5%, their interests are SOOO much lower.

  • bhleigh says:

    I agree you gave solid advice about having a 3rd party mediator. As to her husband’s 30% debt claim, its true. If you maintain a 30% debt level there is only a positive affect on your credit score because the way FICO is calculated shows lenders that you do borrow money but don’t pay it back right away and thats how lenders make their money. If you go above that 30% it starts to be a negative aspect which increases exponentially the higher you go. Here’s a suggestion that might help:

    You want an emergency fund and he wants the 30% balance. Make an agreement with each other that you both create the emergency fund first (you’re happy) and then focus on one of his unsecured debts, like his credit cards, until you get to his 30% balance (he’s happy). Now go back to your consumer debt and make one of them a zero balance (your happy) and then go after his next unsecured debt to a 30% balance (he’s happy). Give going back and forth until you get to the level you both want. I have a feeling that when you show him that you were paying X amount of dollars to debt and now have that in your pocket, he will want to have a zero balance as well. Like the reader above, the numbers will show him everything. Just my two cents…

  • Charles says:

    I second the “lay the numbers out” advice. If someone actually sees that they are paying 6 figures of interest to pay off a $75k loan, they will realize that it’s ludicrous to keeping with it for some credit score.

  • Lakita (PFJourney) says:

    Solid advice.

    The reader’s husband sounds analytical so I would definately do the math and look at the interest and time it would take to pay off debt. Having the numbers in front of him may cause a change of heart.

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