Becoming debt free or even moving closer to that direction can significantly affect your credit score. Payment history and credit utilization are two major factors in your FICO score. Thus, paying off debt establishes a good history and optimizes your credit utilization. Defining "debt free" is somewhat complicated, though.
Debt Free Definition
Debt free is a concept with varying interpretations. Being literally debt free means having no debt at all. This does not jive with conventional societal norms of paying for homes and cars with loans. A more common definition of debt free is having no revolving debt or having no credit balances beyond your mortgage and car loans. Some people simply view debt free as meaning you have no credit card debt. One thing is clear: Reducing or eliminating debt is good for your credit score.
Credit Score Factors
Payment history and amounts owed are two major FICO scoring categories that together account for 65 percent of your credit rating. The FICO model is used by all three major credit reporting bureaus: Equifax, Experian and Trans Union. Length of credit history, new credit and types of credit used are the other three categories of scoring criteria. Lenders rely on your credit score to make decisions on issuing new loans.
Payment History Benefits
The process of making credit payments and becoming debt free simultaneously boosts your FICO payment history scores. You establish a history of making payments, eliminate the possibilities of late payments and other adverse credit events, prevent any past due amounts and increase the number of accounts you have paid on time. All of these positive credit activities improve your payment history, which is the largest single FICO component at 35 percent of the score.
The amounts owed category, which is 30 percent of your score, compares the amount of credit you are using relative to your available credit. By becoming debt free, you optimize your credit utilization ratio. You are using none of your available credit. You would also have zero accounts with balances, which is another important scoring factor in the amounts owed category. It is important to keep your credit accounts open once you become debt free. If you close credit cards, for instance, your credit history and available credit go with them.
- Hemera Technologies/AbleStock.com/Getty Images