Is it possible to pay off debt TOO quickly?
By Erica Sandberg | Published: July 8, 2009
Dear Opening Credits,
Hi, Erica. I own a business, and my debt -- between credit cards and loans -- is divided evenly between the business and personal for a total of $200,000. I'm spending about $5,600 a month just on debt payments, not to mention an average of 20 percent on interest. We're not behind on payments, but the business is struggling more than it needs to because of the debt load. Luckily, my dad is sending me $210,000 of my inheritance early to cover the debt, which sounds great and is great. But the question is: For credit rating purposes, should we pay down the entire debt immediately to increase cash flow and eliminate all interest, or should we set some aside and pay down incrementally? I heard that paying down the entirety immediately can cause a "red flag," as it might show you're dependent on outside sources to pay down rather than your own cash flow. Thank you for your help. -- Don
Consider the figure of $10,000 for a moment. Can you think of a few things you'd like to do with that much money? You could reinvest it into your company, remodel a bathroom or take a much-needed vacation. Or how about tossing it out the window and watching the bills flutter into the street like so much green confetti?
If the last option sounds good, then go ahead and delay paying the accounts. With your current balance and interest rate, that's roughly the amount you'd pay in finance charges if you were to spread the debt out for, say, five months instead of paying it off at once.
OK, I am fairly sure that you really don't want to throw away so much cash, and thanks to your father's generous offer there is no need.
I do understand your concern about the credit impact of paying such a large sum in one fell swoop, though. With credit reports and credit scores, the answers aren't always obvious or logical, and there is a tremendous amount of misinformation out there.
The truth is that instantly eliminating your debt won't act as a warning to others that you aren't as solvent as you seem to be. Instead, it would enhance both your net worth and credit report. According to Todd Huettner, a Denver mortgage broker and president of Huettner Capital, a lender only sees the latest report, which doesn't indicate the previous month's balance. "It's a snapshot," Huettner says. "They won't know any different. As long as you were paying on time, great. Ridding yourself of the debt is the way to go." One thing to remember about credit reports, though, is that they are subjective, and you won't be able to meet every viewer's criteria.
The most commonly used credit score is the FICO score, and in that score's formula, your balance-to-credit-limit ratio makes up 30 percent of the equation. The less you owe, the better your score will be. An underlying reason is that when you are free of financial obligations, you are likely to have more money available to pay future loans. I suggest that you take a trip to the credit score estimator on this site for a free approximation of your score. Play with the numbers; see what will happen to your score if you do X as opposed to Y. Even if you were to see a dip, the $10,000 you'd be saving would probably be more compelling.
In short, Don, stretching your payments out will do nothing for you or your credit rating other than ensure that you pay a huge amount in unnecessary interest charges. Thank your father for the early distribution, use it to pay the balance in full and move away from supporting your business (and personal affairs) with high interest credit cards. Once that burden is gone, you should have much more cash in your coffers to tap into, and you'll become less reliant on loans when you need capital. With the $210,000 gift, you'll have an additional $10,000 after payoff to add to your slush fund, too, which may be wise to tuck away for down times. Most small business fail due to cash flow constraints, so building considerable reserves is critical. In addition, if you would like to borrow in the future, being in the black puts you in a powerful position to obtain premium financing.
And, when finely shredded, old credit card statements really make much nicer confetti than currency.
Meet CreditCards.com's reader Q&A expertsDoes a personal finance problem have you worried? Monday through Saturday, CreditCards.com's Q&A experts answer questions from readers. Ask a question, or click on any expert to see their previous answers.
- With two $0 balance cards, will a new card hurt my score? – Adding a new card will result in a minor hit to score, but it's only temporary ...
- Will applying for, then canceling, new card hurt scores? – A single hard inquiry will temporarily ding your score, but not by much ...
- Can I transfer loan balance to a credit card? – Yes, and you can even save on interest, if you play your cards right ...