When most people think about improving their credit score, they think of paying down their debt and even going so far as eliminating their loans and credit cards so they cannot accumulate more debt. In fact, I just recently read some debt management advice that suggested credit card holders pay off their cards then cut them up and close the accounts. That's bad advice.
The first step (paying down debt) is a good practice to improve credit scores. No disputing that. Creditors like to see lots of "lending room" in your debt-to-income ratio -- they don't like to see maxed-out credit cards.
The second step (getting rid of loans and credit cards altogether) is NOT a good practice. Here's why...
In deciding whether or not to lend you money, lenders ask themselves just one question: "Will this person pay back the loan plus interest, on time and in full?" Your credit report is a tool they use to help them make an educated guess at the answer to that question because it shows how you have handled loans and debt in the past.
So how do you have debt and manage it responsibly to build up a history of good borrowing? Here are two things to know.
The first thing to know is: There are two kinds of loans; installment loans and revolving loans.
• Installment loans are loans that you get once and then you pay back. Once you have paid back the loan, it is no longer available to you. Your mortgage and car loan are two examples.
• Revolving loans are loans that you can use over and over. You get a credit limit and you can borrow money up to that limit, pay it back, and borrow it again. Your credit card and a line of credit are two examples.
Lenders want to see you using both. If you have a couple of installment loans that you have borrowed and paid back (or are currently paying back) and a couple of revolving accounts that you use and pay back and use and pay back, you are demonstrating responsible borrowing.
The second thing to know is: Lenders want to see that you have a couple of loans of each type to demonstrate your ability to manage debt. It's a balance between having some loans to show a good repayment history and having too many loans that you are unable to pay them back and if you are maxed out.
Often, I'll have new clients in my office who are shocked at their poor credit scores even though they are proud of how little they've borrowed. They're surprised to learn that you need to borrow responsibly to maintain a higher credit score. If you are not using credit, how can you keep maintaining a healthier score? You really can't. Now I am not saying rack up debt, but if you pay certain bills monthly anyway such as some utility bills why not attach it to your credit card and pay it that way.
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