Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006).
Dear To Her Credit,
I will
be divorced within the next two months and starting over again. The housing and
rental market I'm in right now is crazy. To me it makes no sense to rent, and I
can't really afford to, but I can't afford to buy either.
I
recently started a new job with a government agency, so my health care and
retirement are set as long as I stay there. If I cash in all my 401(k) plans,
annuities, and a portion of my savings, I could pay off my debts and still have
enough cash to cover the early withdrawal fees. My question is, will doing so create
negative effects when I approach a lender for a mortgage? -- Ruth
Dear Ruth,
Cashing
in your savings and retirement accounts and paying off your debts would
probably have a positive effect on your credit score. There's a lot more to
think about before you make such a drastic move, however.
High
credit card balances by themselves do not hurt your credit score. What matters,
according to Barry Paperno, consumer operations manager of FICO score developer
Fair Isaac,
is your credit utilization percentage. That's the percentage of your available
credit that you are using. "Strictly talking about the score, if she did that,
if her credit was 80 percent to 100 percent utilized, and she paid it down to
being 0 percent utilized, it could impact her score."
Let's
say you have a low score due to high balances in proportion to your available
credit. Paperno estimates that getting rid of your debt could improve your
score by upward of 100 points -- a huge difference!
Paperno
cautions that if a low score is the result of late payments, paying off debts
can only help so much. It won't help the 35 percent of your score that is
determined by your payment history. "How you got to where you are has
everything to do with how a certain action will change your score," he says. You
can turn your credit utilization percentage around overnight by paying off your
debts, but re-establishing a good payment history takes time.
Just
because cashing in your savings and retirement plans to pay off debts will help
your credit score doesn't mean it's a good idea, however. Consider these
factors:
The credit bureau doesn't
look at the money you have in savings, but your potential mortgage lender surely
will. Emptying your savings may hurt your chances of getting a loan even though
it helps your credit score.
You need an emergency fund
at all times. Don't use every dime to pay off your debts, leaving you with
nothing for emergencies.
Try not to touch your
retirement funds. Saving for retirement is essential -- try to think of
that money as out of sight. The 10 percent penalty on early withdrawals sets
you back, too.
You can improve your credit
utilization percentage in other ways. It's the credit utilization
percentage, not the balance on the debts that affects your credit score, so
ask your credit card company for a higher limit. For example, if you owe
$5,000 on a card that has a $5,000 limit, and you can get the limit raised
to $10,000, your utilization of that card drops from 100 percent to only
50 percent. That's a big difference in your favor!
Instead
of cashing everything in to pay off your debts, I recommend paying as many
debts as you can without touching your retirement plans. Then, make a plan to
pay the rest of the debts off as quickly as possible.
Now that
you have control over your own financial life, you can start to build a better
credit score. Congratulations, and good luck working toward your goal of buying
a home!
Sally Herigstad answers questions about credit every week for CreditCards.com. Herigstad is a certified public accountant, author and speaker. She also writes regularly for MSN Money, Interest.com, Bankrate.com and RedPlum.com, and has been a guest on Martha Stewart radio and other programs. You can read more about personal finance and download free budgeting worksheets at her website: www.sallyherigstad.com
To Her Credit answers a question about a debt or credit issue from a CreditCards.com reader each week.
Send your question to Sally.
Published: August 8, 2008
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