Managing Your Debt and Credit Score
By Amber Shrosbree, CFP®
Someone was recently asking me for advice on how to improve their credit score. They were telling me about the steps they had already taken between loan consolidation, paying off some balances, and closing accounts. They were shocked when I told them that closing accounts was actually detrimental to their credit score, and that they may end up paying even more by consolidating their debt.
Credit Balance
Managing your credit card balance and overall credit usage percentage is a critical part of maintaining a good credit score. A good rule of thumb is to keep your credit utilization below about 30%. For example, if you have about $15,000 worth of credit available to you through your credit cards, the goal should be to keep your usage at $4,500 or lower.
There is a bit of a dance that goes on when managing your credit card balance. While the goal should be to get your credit card balance to $0 on a monthly basis, this should not mean you cut your cards up to prevent yourself from using them at all.
The sweet spot is when it has been established that you have been able to keep your credit usage low without forfeiting the use of your credit altogether. It takes more discipline to use your credit card wisely than to not use it at all. This is when you will see a really healthy credit score.
The advice that has always stuck with me is if you do not have a plan to pay for it you should not buy it with credit. Only put on credit what you know you can afford with your paycheck.
Do not close accounts
This ties into the final point above. It does not necessarily benefit you to cut yourself off from your cards, or close your accounts. In fact, closing an account is something that can actually harm your credit score. Your credit score not only takes into account your credit usage, but how long you have had your accounts open. The longer an account remains open and established, the better it is for your credit score. Of course, as noted above, the account needs to be properly managed. No open account benefits you quite as much if it is constantly maxed out and never gets paid down.
Tricks to paying down debt
It is not uncommon to end up with more debt than you would like. Life happens, but there are ways to pay it down more efficiently to get yourself out of the hole faster.
1. Make payments more often.
Even if they aren’t huge payments, by making payments more than once a month, you give your balance less time, and less of a balance to continue to rack up interest.
2. Pay more than the minimum requirement.
Pretty straight forward, but by paying more than the minimum required payment monthly you ultimately shorten the lifespan of your debt and the overall amount you will pay to pay off the debit. The smaller your payments, the more you pay in the long run.
3. Pay highest Annual Percentage Rate (APR) off first
Prioritize the accounts that are generating the most interest. Pay the minimums on your other accounts while you focus your attention on the one growing at the fastest rate.
4. The Snowball Method
This is an alternative to paying off the highest APR first. Here, you focus on paying off the lowest balance first. Once your lowest balance has been paid off you move onto your next lowest balance and roll the funds you were putting towards the first bucket toward your new lowest balance bucket and so – on.
Be wary of debt consolidation offers
While the idea of getting all of your credit card payments bundled into a single monthly payment sounds nice and more manageable, there are things to consider before moving forward with debt consolidation.
· How long is the life of this new loan compared to your current ones?
· Is the rate I am being offered fixed or variable? In other words, will the low rate I’m being offered now end up growing down the road?
· How does the rate I’m being offered compare to the weighted average interest rate of my existing debt?
Once you have gathered this information, you need to figure out if you will truly end up paying less by consolidating, or if you’re actually going to pay more in the long run.
Of course, there is no one perfect way for everyone to manage their debt. Each situation is unique, and life inevitably throws curveballs and can derail a perfect plan. As always, we are available for any of our clients who may feel as if their debt has become overwhelming and are seeking guidance on how to manage it and where to start.