If you’re thinking about buying a home and need to improve your credit score, one of the fastest ways to accomplish this is to take a bite out of your debt. The big question is where to start.
Here are a few things to consider before you start paying down in earnest.
Understanding Your Debt
It’s important to make sure that you are aware of exactly how much you owe and where the problem areas are in your credit score.
If you haven’t already, start by obtaining your free credit report. Make sure the report is accurate and doesn’t contain errors or omissions that are hurting your overall score.
To do this, it’s also essential to understand how your credit score is calculated. The two biggest factors are payment history and amounts owed.
Carla Blair-Gamblian, loan officer for Veterans United Lighthouse Program, recommends making sure you have established on-time payment history before you start attacking specific debts. Once you’ve done that, lowering your utilization rate, or the ratio of amount borrowed to amount available, can be a powerful tool for improving your overall credit score.
Types of Debt
There are two main types of debt – installment and revolving.
Installment debts are one-time loans that you agree to pay back at regular intervals, generally a set amount over a fixed period of time. They are usually backed by an asset. These types include your auto loan, student loan or current mortgage.
Revolving debt, on the other hand, sets your monthly payment based on the current balance. These loans are unsecured, which means there are no specific assets to use as collateral. This is the type of debt that credit cards offer, and where most people get into trouble. The good news is that paying down these debts is one of the simplest ways to quickly improve your credit score.
So which debt should you tackle first? The short answer is, “It depends.”
Just because a debt has a higher interest rate doesn’t necessarily mean you should pay it off first. Many financial experts recommend the “debt snowball” method in which you pay off your smallest debts first, regardless of interest rate. While this may seem counter-intuitive, recent studies support this strategy as there are psychological benefits to being able to see your progress and it becomes easier to maintain momentum.
Mathematically, it’s almost always going to make more sense to pay down your high-interest debt first because it will save you money in the long run. However, credit problems typically have more to do with short-term spending behavior and less about how you calculate your long-term budget.
It’s important to find a plan that works for you. No matter which route you decide, developing good financial habits is going to be key to your success.
If you’re looking for more info on this topic, check out our Guide to Credit Scores.