This post originally appeared March 31, 2016 on CreditCards.com as “Pay off revolving card debt first over installment loan”
By Barry Paperno
Dear Speaking of Credit,
I am paying off my debt and have a credit card and installment loan open, both with about the same balance. The installment loan has a high interest rate, much higher than the credit card. In terms of helping my credit score and avoiding interest combined, which balance would you suggest I pay off first? – Bill
As I see it, the conundrum you face in your attempt to both lower your interest expense and help your score by initially paying off one of your two balances is that the higher-interest loan you want to pay off first is the debt having the least impact on your credit score.
Why should it matter to the score if the debt is in the form of an installment loan or a revolving card account? After all, debt is debt, right? Well, not exactly.
Research into consumer credit behavior conducted over many years by FICO and other credit scoring companies has overwhelmingly shown that revolving debt carries a higher risk of future default than does installment debt. In other words, consumers tend to miss payments on revolving card balances more frequently than on installment debt. This is why, within the “credit utilization” scoring category that accounts for 30 percent of your score, credit scores assign many more points – both positive and negative – to revolving than installment debt.
On a much smaller scoring scale, that same research has also found a slightly lower likelihood of late payments among consumers whose credit reports contain both open installment and revolving debt than among people using only one of these types of credit. While fewer points are at stake within this “credit mix” scoring category, which makes up 10 percent of your score, for you, closing either account entirely could cost your score a few points.
How then to decide which account to pay first? Start by taking a realistic look at your current financial situation and then identify any short- and long-term future financial expectations. For example, do you plan to buy a home or car within the next couple of years? Or are you pretty secure for the time being and don’t see any major purchases on the horizon?
Let’s look at a few possible strategies to consider:
Preparing for a major purchase.
A higher score at loan application time could help you qualify for lower interest rates, which could mean saving hundreds of dollars on a car loan or thousands over the life of a mortgage. A strategy for raising your score by paying off your card balance first, while also leaving the account open, could save you more in interest over the long run than by paying off the loan now to avoid interest.
No big purchases planned.
Here, you can achieve your goal of paying less interest now by retiring that high-interest installment loan. Be forewarned, however, that you are not likely see any improvement in your score – and perhaps even a slight temporary drop, as mentioned above – when your credit report no longer includes an open installment loan. If this happens, though, rest assured that any lost points can be earned back within a few months or less, as long as you continue to pay your card account on time without increasing the balance and don’t open any new accounts.
Middle ground solution.
Whether your future includes a major purchase or your plans are less ambitious, you may want to consider a compromise in which you pay each debt down by half. This way, you’ll reap at least some of the benefits of lower interest and higher score. If nothing else, this could be a good tiebreaker solution if you can’t decide which of the above ways to go.
Fortunately, no matter how you apply your payments, you’ll be in the enviable position of cutting your overall debt in half. And whether you end up lowering the interest you’re paying or raising your credit score – or both – anytime you substantially reduce your debt, you’re on the right track.