My friend has a poor credit score. She already has some credit cards as well as a personal loan with fixed monthly installments ending in next six months. So my question is, what will help her more, paying the balances of the credit cards first and then clearing the loan as scheduled, or paying the loan off early and then the balances on the cards?
Installment Credit is a Loan with Specified Monthly Payments, Terms, and Interest
An installment loan is a credit account where you borrow a fixed sum of money and agree to make monthly payments of a set dollar amount until the loan is paid off. An installment loan can have a repayment period of months or years. Some common types of installment loans that are often seen on credit reports are home mortgages and car loans, and typically involve fixed or variable interest rates with some requiring additional fees.
Unlike a revolving account, once an installment loan is paid off, it is considered closed. Paying an installment loan as agreed and in full will have a positive effect on credit scores. However, paying the loan off early probably won’t have a significantly greater impact on the scores than simply paying it off on time. A closed account in good standing will also stay on your credit for 10 years and will continue to benefit your credit standing.
Credit Card Accounts are Revolving Accounts with Credit Limits
A credit card account is an account that lets you carry a balance from month to month, or revolve. In your credit report, a credit card account is shown as a “revolving” account. The revolving account has a limit on the maximum balance you are allowed to charge up to.
With a revolving account, you decide how much to charge every month and how much to repay. When you carry a balance over from month to month, your incur interest fees, which add to your total balance owed.
One of the top factors in determining your credit scores is your utilization rate, or your balance-to-limit ratio. Your utilization rate is calculated by adding up the total of all your credit card balances and dividing that number by the total of all your credit card limits. The lower your utilization rate, the better.
Paying off the balances on your friends credit cards will help increase your friend’s credit scores. Doing so can also help her save on interest fees, which would be good for her wallet, too! While paying down high balances on credit cards will usually have a positive effect on credit scores, paying off an installment loan early isn’t as likely to help scores.
Improving Your Credit Score by Paying Attention to Risk Factors
The best thing advice you can give your friend is to order recent copies of her credit reports and scores from each of the three credit reporting agencies.
In addition to the number, she should also receive a list of risk factors that explain what from her credit report most affected the score.
These factors will tell her what on each of her credit reports is having the most impact on her scores currently. Paying attention to these risk factors will help her understand what changes she can make to help increase her scores in the future.
Usually, reducing the balances on your credit cards will have a greater impact on your credit scores more quickly because the utilization rate is the second most important factor in credit scores.
Thank you for asking,
The “Ask Experian” Team