Your credit score is a complicated mix of factors, such as how much you owe, how timely your payments are, the kind of credit you have and how long you’ve had that credit. Rating companies use proprietary formulas to come up with your credit score, which is used to determine how credit-worthy you are. Lenders use this to decide whether to loan you money and, if they make the loan, how high your interest rate will be. Paying off your debts can help to raise your credit score and make it easier for you to get new credit, such as a mortgage or a new car loan.
The Fair Isaac Company is one of the most commonly used sources of credit ratings, a number often referred to as your FICO score. While the company won’t reveal exactly how they come up with the number, the company’s consumer information page reports that 35 percent of your FICO score is based on whether your payments are made on time, and 30 percent of it is determined by how much money you owe to creditors. Changing either of these two things can have a major impact on your credit score.
Reducing the amount of debt you have will raise your credit score, but how much depends on your situation. According to Yahoo! Finance, every maxed-out credit card you have can drop your credit score by anywhere from 10 to 45 points, and paying it off has the potential to raise your score by the same amount. If you have a lot of debt and pay off a credit card with a small balance, it might not have a very noticeable effect on your FICO score, but if you pay off a credit card that substantially reduces your level of debt, it will increase your score significantly.
If you choose to pay off a credit card by making regular payments, it is important to make them on time. This not only lowers the amount you owe, but it also helps to boost your score by adding to your history of on-time account payments. Because these are a significant factor in your credit score, carrying more weight than your overall debt level, making regular payments as you pay off a credit card significantly increases the benefit to you.
If you pay off a credit card, then close the account, it can actually lower your credit score because it decreases your available credit. Older accounts help your score by showing a long-term credit history, and when you close them, you lose that. Opening new accounts so that you have credit available can also affect your score negatively, as can having too many credit inquiries show up on your credit report. The impact of these actions is more pronounced if you have a short credit history, but it can affect people who have had credit for a long time as well.
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