If high credit utilization is weighing down your credit score, a tax windfall can help you pay down your card balance. But if you have multiple balances, it can be tricky to decide which ones to pay down, and by how much.
Dear Keeping Score,I currently have a Wal-Mart credit card, a Victoria’s Secret credit card, two Visa credit cards and one Mastercard credit card. I need to get my credit utilization down, as currently my Wal-Mart card and two credit cards are basically maxed out. One is $3,000, one is $2,000 and one is $1,300.
My question is this: With our tax returns, I will have $3,500 to use to pay down my cards. Would it be better to pay them all down, or to pay a few off, leaving one card almost maxed out? I was thinking of paying off the highest one, which is $3,000, then do balance transfers to pay off Wal-Mart and the other credit card, leaving a zero balance on all my cards, except the one which will then be maxed.
What is the better option? What would look better, as I need to do this because we are applying for a mortgage soon. Any help would be greatly appreciated. – Marcy
Kudos to you for choosing to use your tax refund to retire some debt! Using refund money or any other windfall funds are thoughtful and responsible ways for anyone out there with debt to improve their credit score (and overall financial health).
But for your specific question, the answer lies in what you say at the end. When you are in the market for a mortgage, being very sure that all of your credit ducks are in a row becomes even more important. This is especially true when it comes to your credit score.
This credit-score-duck-lining-up process is likely to become a bit more complicated since the Federal Housing Finance Agency recently authorized Fannie Mae and Freddie Mac (which back close to half of all mortgages in the U.S.) to factor in credit scores besides the traditional FICO score.
This means that in addition to knowing what your FICO score is, you now also need to know what your VantageScore is. The two scoring giants both use a 300 to 850 point scale, but how your score is derived varies by scorer and the particular version of a score that is being used by a lender.
FICO is now up to FICO 10 (with 8 and 9 in common usage) and VantageScore is up to 4.0 (with 3.0 also still in use). Additionally, free scores provided from online sites may use an older version of either score, further complicating knowing exactly where you stand.
Finally, there are other alternative credit scoring methods that can affect your score. For instance, some scores incorporate bank account data, utility payments or rental data into your score. The bottom line is that it is nearly impossible to expect the score you get from the bureaus or an online site to be exactly the same as the score your lender uses, and the difference can be significant!
First, a quick review of the factors that make up your VantageScore and FICO score:
FICO 8 and 9
- Payment history is the most important factor, at 35%
- The second biggest factor is credit utilization (including total debt and percentage of credit line used) at 30%
- Length of credit history makes up 15% of your score
- New credit and credit mix (types of accounts you have) each count for 10%
- Total credit usage, balance and available credit are “extremely” influential, per VantageScore’s terminology
- Credit mix and experience are “highly” influential
- Payment history is “moderately” influential
- Age of credit history and new accounts are “less” influential
(Note that VantageScore doesn’t use percentages of importance for its scoring factors.)
See related: How FICO’s new credit score changes will affect you
Using your tax refund to reduce your credit utilization ratio
Your question involves credit utilization. This factor looks at overall utilization as well as at the individual usage on each card. No matter how you apply your refund, your overall utilization number will be the same.
With $6,300 in maxed-out cards and $3,500 to put against those cards, you will roughly end up with an overall balance of $2,800, or 45%. I say “roughly” because this calculation does not take interest charges into account.
But sticking with the “rough” analogy, the best break when it comes to utilization is to be at 25% or less. To get to 25%, your $3,000 card would need to have a balance of $750, your $2,000 card $500, and your $1,300 card $325.
To get to at least 25% utilization on all three cards would cost you $4,725 and you say your refund will be $3,500, so your tax refund alone will not be enough to put you in that range. But it will make a significant dent in your credit utilization ratio, and should bring your score up.
However, you may benefit most from paying your $3,000 card down to a balance of $750 (25% utilization) and then applying the remaining $1,250 to the two smaller accounts. There are two benefits to this approach.
First, your highest limit card will be at 25% of its maximum (a plus for individual utilization). Second, the other two cards will be over the 25% number at 38%, but they won’t be as close to their limits as they were (points are lost as you approach your maximum limit).
Keep making payments on time, and pay more than the minimum
One quick note: keep in mind while you are deciding what to do with your tax refund that you will still need to pay at least the minimum on your other cards at the same time. As noted, payment history is the most influential factor in credit scoring. So you must be sure to pay all of your bills as agreed on time, every single time.
Personally, I would like to see you paying more than the minimum on the others if you can swing it, but at the very least you must make any payment on time.
I also recommend that you look at all of your cards and their usage. Remember that there is an overall utilization ratio, so just because your other cards are not maxed out does not mean that they are below 25% utilization, which is what you want. If any are over, you will also need to see what you can do about getting those paid down.
Even a few extra dollars more than the minimum per month can make a difference. You can see this for yourself on your credit card statements, in the box that says how long it will take to pay off your card with just the minimum payment.
There is often another line showing how paying an amount larger than the minimum (usually not significantly more) can bring the time down quite a bit. You can also plug your cards into CreditCards.com’s handy payoff calculator to see this for yourself.
This can be a valuable exercise and quite eye-opening if you have never done it before. It will be well worth your time to find out exactly where you stand before you start mortgage shopping.
Expecting a big refund? Consider adjusting your paycheck tax withholding
One last question – what are you doing getting a $3,500 refund? I recommend you don’t allow this to happen again! That’s $3,500 you loaned interest-free to the IRS while you were paying God knows what interest rate on your cards.
If you expect another fat refund, look at changing your paycheck tax withholding so you end up with somewhere around a $500 to $600 refund and no more. That way you’ll have more money in your paycheck to pay off your balances every month.
Remember to keep track of your score!